Risk Returns The following was excerpted from Third Eye Capital Management Inc.'s Q1 2015 Investor Letter.

Investors will need to become more discerning as the bull market rally in stocks and bonds matures. Broad allocations to indices was a winning strategy for the past seven years but investors have reason to be cautious since the policies that drove asset prices higher are close to an end. Confidence in the economy and stability of credit markets are now priced into financial assets, as demonstrated by zero risk-free rates and extremely low credit risk premiums. Predictably, investors in equities are willing to pay richly for projected future income streams in advance of any evidence of tangible results. However, as such expected growth gets priced into stocks, the future returns for equity investors get eroded. The appetite for yield and growth is intense among investors and this hunger continues to promote equities over fixed income (as well as concentration over diversification). We expect stock market volatility to increase as investor reluctance to abandon equities conflicts with the Fed’s signals about pending interest rate normalization. It has become increasingly more challenging to take passive exposures in the public fixed-income and equity markets. We have always considered security selection as being critical, and are convinced that active management will be more helpful to investors in the current environment than indexing.

Private debt does not have an investable tracking index but investors can express a view on corporate credit markets through high yield and leveraged loan indices. The lending markets are highly fragmented and informational asymmetries that determine risk premiums can vary widely. In the small and middle market segments, supply of credit is low and in decline due to the antipathy of banks and greater regulation, and demand is high due to traditional reliance on loans and general lack of other financing options such as equity. In Canada, the overwhelming majority of companies in this segment are non-sponsored, tend to be closely-held, and do not publish financial information; this makes the sourcing and analysis of such opportunities more challenging and the population of credit providers small. Corporate credit indices cannot capture the benefits of structural imbalances in small and middle-market credit where participants are less active and risk premiums are more persistent.

Traded fixed income is no longer a volatility dampener nor a source of reliable yield. If credit investors want to flourish going forward then they will need to consider complementing their traditional asset allocation with high-potential alternative strategies within private debt. In any skill dependent activity, performance dispersions among participants can be high and private debt managers are no different. Investors should focus on managers that possess multi-year experience applying a disciplined credit underwriting approach in a variety of situations and undesired circumstances, especially defaults, with a track record of consistently repaid and recovered loans.

Third Eye Capital Management Inc.