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October 26, 2016

Dear Clients and Friends,

Investment Commentary

The investment landscape continues to present challenges to the prudent investor with nearly 1/3 of developed country debt trading at negative yields. In other words, instead of earninginterest, an investor elects to payfor the privilege of loaning out money.If you look at any finance textbook, you will not see any mention of negative yields. Theoretically, they should not exist. In addition, only 6% of developed country debt is yielding over 2%. To get the meager 2% yield, one must invest in bonds maturing a few decades away. If there ever was an example of a "return-free" risk, this is it.

For bonds, the math is pretty straightforward. Investing in a 10-year Treasury bond at the current rate of 1.74% and holding to maturity, yields an annualized return of precisely 1.74%. (Note: The 30-year Treasury is yielding near a historic low of 2.48%).

While central bank intervention in the markets to suppress interest rates was touted as necessary to revive the global economy, global growth continues at a tepid pace. No matter, central bankers have continued down this same course and seem to respond swiftly any time there is a stock market decline. The promotion of ultra-low or negative rates was intended to encourage business investment and economic growth. Sensing inconsistent demand growth, not enough businesses have elected to take advantage of low rates to build capacity. This is not a path that leads to a healthy, growing economy.

Low interest rates have been the fuel that has driven asset prices higher, including returns for both of the mainstream financial asset classes of stocks and bonds. As a result, these two asset classes no longer provide significant diversification benefits on their own. Their prices have been moving in lock step with changes in or forecasts of interest rates. An actual or expected rise in interest rates would likely translate into giving back gains.

This is not to suggest that stocks and bonds do not have a place in a portfolio, but simply that: 1) in combination they are unlikely to provide the same portfolio stability as they have historically and 2) the odds are not in their favor to provide returns close to their long-term averages.

Alternative investments (alts) have become a growing opportunity asset class for investors looking for non-correlated sources of return. Historically, the challenges presented by alts have included: higher costs, complexity, and limited availability to much of the investing public. Over the years, alts, which started in the hedge fund industry, have progressed to the more accessible and lower cost mutual fund and Exchange-Traded Fund (ETF) universe. With lower returns expected from mainstream asset classes, and resulting heightened risks, we believe that alts deserve a larger allocation in portfolios. There is no historical precedent for a combination of high valuations and low bond yields to produce good returns for stocks or bonds.

Thus far, Ironclad Managed Risk Fund (IRONX), which was one of the originators in the option-writing space, has a sizeable allocation to client portfolios. Copycat funds have been launched and we have found a good complement to IRONX in the LS Theta Fund Institutional Class (LQTIX). They both use substantially similar strategies, but their nuanced differences will cause them to ebb and flow a bit differently. We will look to spread the option-writing exposure more evenly between these two funds in the coming months. Enclosed is a fact sheet on LS Theta.

Additionally, we will add two market-neutral strategies, SilverPepper Merger Arbitrage Institutional Class (SPAIX) and Vivaldi Merger Arbitrage Institutional Class (VARBX). These strategies make their money by investing in companies that have an excellent chance of completing an announced merger. The correlation of these funds is virtually zero to stocks and bonds, since their performance is completely event driven (the merger happens or it doesn’t). In addition, both option writing and merger arbitrage strategies are positively correlated to interest rates, which make them good diversifiers. Should rates continue to stay low and valuations high, we could muddle through at mid- to-low single digit returns. The alts strategies should provide good defense against rising interest rates, given the expected inverse correlation that rates have on traditional stock and bond assets classes. The funds will replace some of the high-quality fixed income exposure in client portfolios. Fact sheets on SilverPepper and Vivaldi are included.

Investment Policy Update

The benefit of an Investment Policy Statement (IPS) is to have a written understanding of investment guidelines, created in a rational setting, which will enhance consistent, disciplined, and prudent investment management. Having clearly established guidelines should reduce the probability of initiating impromptu portfolio changes that could hinder the achievement of established objectives.

When drafting the IPS we consider expected contributions or withdrawals to the portfolio, and the extent of each. This is known as risk capacity. We also attempt to measure risk tolerance by understanding a client’s actual responses to market declines and the results of risk tolerance questionnaires. If an investor is unable to refrain from liquidating financial assets during declines, the investment plan will be short-circuited.

Traditionally, guidelines as to the percentage of stocks versus bonds in a portfolio were sufficient to manage portfolio risk. Given unprecedented low global interest rates, this is no longer the case. Risks associated with financial markets are notstatic.Historical evidence shows that higher valuation in stocks is not just associated with lowerreturns, but also with an increased magnitude of stock market declines. Similarly, lower bond yields are associated with lower, and possibly negative, returns.

There are professional risk management tools existing today that enhance an advisor’s ability, within limits, to measure the statistical relationship between specific economic levers and the movement of investment values. These levers include, but are not limited to: inflation rates, economic growth, commodity prices, geopolitical events, and currency movements. Using these tools, an advisor can better understand the potential drawdown risk (risk of portfolio decline) of an existing portfolio and its many moving parts.

Our objective will be to design portfolios with an expected maximum drawdown percentage (loss tolerance) that allows an investor, even during extreme events, to stay with and not abandon a long-term investment plan.

We will also use tools that attempt to measure each investment’s volatility, its range of returns compared to an average, as well as the estimated volatility of the total portfolio. This will enable us to rank investments from low volatility (relative price stability) to higher volatility (less price stability, but higher potential returns).

As a result of the above, we will be utilizing a new IPS format and reformatting our quarterly household portfolio reports. We believe this refined approach will enhance our ability to assist you in achieving your financial objectives in the challenging years ahead.

We continue to work daily to earn your trust and confidence.

Best Regards,


Vincent A. Schiavi, CFP®, CPA/ PFS                            Ravi P. Dattani, CFP®, CPA
President                                                                           Vice President  


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