Litman Gregory Masters Alternative Strategies Fund First Quarter 2017 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 1.24% for the quarter ending March 31, 2017. During the same period, the Morningstar Multialternative Category gained 1.62% and 3-month LIBOR returned 0.25%.i

Performance quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the funds may be lower or higher than the performance quoted. To obtain standardized performance of the funds, and performance as of the most recently completed calendar month, please visit www.mastersfunds.com.

Quarterly Review

With U.S. equity market valuations relatively to egregiously high (depending on one’s perspective), high-yield bond spreads back near the tightest levels of the last five years, and still-uninspiring yields in “safe” government and investment-grade debt, there seem to be few areas of compelling opportunity for investors in traditional asset classes. Even sectors and regions that were left behind in the immediate aftermath of election euphoria (e.g., technology, health care, emerging markets) have rebounded significantly in the first quarter.

This is not to say that there are no interesting investment opportunities for our managers. For example, structured credit still offers good risk-adjusted expected returns, and merger-arbitrage spreads remain fairly attractive with good deal flow and a supportive backdrop in terms of credit availability and a friendlier regulatory environment. And there are always idiosyncratic, bottom-up, security-specific names with attractive return potential relative to their risk. However, looking at the positioning across our sub-advisors at quarter-end, we see for the most part more caution than aggressiveness. This is characterized by higher cash balances than four to six quarters ago, more conservative positions where there are significant net exposures, a focus on short-duration situations, and a balancing of long-biased positions with short-biased ones in event-driven names.

We think this is prudent. Market volatility expectations, as measured by the VIX index, has been bumping along in the low teens despite, among many other considerations, more uncertainty and turmoil (and of a distinctly different variety) than usual in Washington, a number of important elections in Europe along with the start of Brexit, and a Korean peninsula that is more unstable and potentially dangerous than it has been in years. There are always potential trouble spots in the world, and by definition, the future is uncertain. We don’t think anyone can consistently predict geopolitical events or short-term financial market returns. Sometimes, though, the markets pay you more to invest and take the risk of that uncertainty than others. Those are the times we expect our managers to be more aggressive in deploying capital. Other times, grinding out a decent return and preserving the optionality of investing in a better opportunity set makes more sense. Volatility creates opportunity.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 3/31/17
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
5.43 2.39 16.84 1.71
Total Cumulative Return
33.77 13.85 135.32 9.79
Annualized Std. Deviation
3.28 2.81 10.95 3.27
Sharpe Ratio (Annualized)
1.59 0.80 1.47 0.50
Beta (to Russell 1000)
0.25 -0.02 1.00 0.26
Correlation of MASFX to…
1.00 -0.13 0.79 0.82
Worst Drawdown
-6.94 -4.52 -12.41 -9.33
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.90
% Positive 12-Month Periods
86.21% 82.76% 94.83% 79.31%
Upside Capture (vs. Russell 1000)
31.45 7.11 100.00 21.06
Downside Capture (vs. Russell 1000)
27.64 -8.30 100.00 41.67
Since inception (9/30/11).
Worst Drawdown based on weekly returns
Past performance is no guarantee of future results

 

 

 

 

Quarterly Portfolio Commentary

Performance of Managers

For the first quarter, four managers produced positive performance and one produced a loss. The FPA Contrarian Opportunity strategy gained 3.31%, DoubleLine’s Opportunistic Income strategy was up 1.50%, the Loomis Sayles Absolute-Return Fixed-Income strategy returned 1.31%, and Water Island’s Arbitrage and Event-Driven strategy gained 1.08%. On the negative side, Passport’s Long-Short Equity strategy lost 2.42%. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DoubleLine: The Opportunistic Income strategy’s 1.5% gain outperformed the Bloomberg Barclays U.S. Aggregate Bond Index return of 0.82%. The U.S. Treasury curve flattened slightly during the period with 2-year U.S. Treasury yields increasing by about 7 basis points and 10-year yields declining by about 6 bps. Agency residential mortgage-backed securities (RMBS) performance was bifurcated between fixed-rate securities and derivative structures. Fixed-rate collateralized mortgage obligations (CMOs) and principal-only securities (POs) were the highest contributors to total return, while inverse floating-rate securities and inverse interest-only securities were the worst performers. Fixed-rate CMOs and POs benefited primarily from strong price appreciation during the period, while the inverse products faced price declines, though some of this was negated by high coupon returns from the sectors.

Amongst non-agency RMBS, Alt-A bonds were the best performers due to the combination of healthy price gains and robust interest carry. Prime and Subprime bonds performed similarly for this period from a total-return standpoint. Municipal bond holdings detracted from performance as valuations were under pressure; however, other structured credit sectors like collateralized loan obligations (CLOs) and commercial mortgage-backed securities (CMBS) were accretive to performance as credit spreads tightened in both sectors. The portfolio ended the quarter with non-Agency RMBS still the largest allocation at about 56%, but cash was significantly higher (almost 16%) than a quarter ago, and as high as it has been in several years.

FPA: The FPA Contrarian Opportunity strategy generated good performance (up 3.3%) in the first quarter, particularly relative to the level of cash held in the portfolio, which increased from the mid-30% range to approximately 41% over the course of the quarter.

There was fairly light activity in the quarter. The managers sold a small but very long-term position in Alleghany at a large profit and trimmed American Express, taking decent gains over the year-plus holding period. On the losing side, Perrigo, a health care name that was added during the post-election selloff in that sector, was exited at a small loss, and longer-term position Countrywide was sold with a more material loss after the investment thesis failed to play out. The portfolio received an allocation of a Sears Canada term loan in which FPA participated and added to a different health care position that was also purchased in the fourth quarter of 2016.

The top contributors for the quarter were Arconic, Oracle, Leucadia National, Cisco Systems, and Bank of America. The largest detractors were Walter Investment Management debt holdings, Regis, AIG, Qualcomm, and General Electric. The gross long exposure to equities ended the quarter at 54% (approximately 49% net), including 14% in non-U.S. companies. Credit holdings are 8.9% of assets. The largest concentration remains in financials, including Citigroup, AIG, Aon, CIT Group, Bank of America, and Leucadia. Technology is second, with large, high-quality franchises like Oracle, Microsoft, Cisco, and Alphabet (Google). The high cash level reflects FPA’s difficulty in finding attractively priced positions in a market they view as broadly quite expensive. They have been opportunistic in adding to select areas (e.g., high-yield) during periods of market turmoil in recent years but are currently finding very little attractive enough to commit new capital.

Loomis Sayles: The Absolute-Return Fixed-Income strategy continued to benefit from key drivers of 2016 returns (but to a lesser extent), gaining 1.3% for the quarter. Securitized assets, particularly asset-backed securities (ABS) and non-agency RMBS, contributed to performance as fundamentals remained stable across all sectors and investor sentiment was positive. High-yield corporate bonds, the biggest contributor last year, generated positive returns again in the first quarter, as spreads continued the strong tightening that followed the U.S. election, before slightly widening during March and ending the quarter close to the tightest levels of the trailing twelve months. While euphoria has faded a bit, market optimism generally persists due to the new administration’s desire for lower corporate tax rates, reduced regulatory oversight, and increased infrastructure spending. The combination of a relatively patient Federal Reserve, improving earnings and credit metrics, stable to higher commodity prices, and a general search for yield continued to have a positive impact on high-yield prices. Individual energy, communications, and consumer non-cyclical names were the most significant contributors.

Investment-grade corporate bonds also boosted performance as spreads tightened. Despite questions about the Trump administration’s ability to enact its policies, investors continued to focus on the potential positives for the time being, while economic numbers came in mixed to strong during the quarter. Most of the positive contribution came from energy and banking names. Emerging-market exposure also boosted returns, as emerging-market credit rallied in the first quarter following a volatile and generally negative end to 2016. Despite investor concerns over U.S. trade policy, U.S. dollar strength, and political uncertainty, emerging markets posted impressive gains, attracting further investment flows. Energy, banking, and capital goods names in the portfolio led the positive contributors.

On the negative side, dividend-paying equities weighed on performance despite solid U.S. equity market gains during the quarter. The portfolio’s small allocation to equities is dominated by energy positions, which were hurt by lower oil prices. The Loomis Sayles team remains comfortable with these positions due to their expectation of modestly higher oil prices over the next few years. The portfolio’s largest net long allocations remain in securitized (22%), high-yield corporate (19%), and investment-grade corporate (17%).

Passport: Passport’s Long-Short Equity strategy continued a disappointing stretch of performance, declining 2.4% in the quarter. Equity longs contributed approximately 2.8% while shorts detracted 4.9%. On the long side, the Internet/technology sector contributed 2.3%, driven by the portfolio’s exposure to “China Internet” (primarily Yahoo! as a cheaper proxy for Alibaba Group Holding), Western Digital, and semiconductor stocks. The largest detractor (down 2.0%) on the short side was the portfolio’s group of index hedges, focused on emerging markets, which rallied strongly. The consumer discretionary and health care sectors also each detracted 0.9% over the first quarter.

The fairly extended period of weak performance has led to changes at Passport that will impact the liquid long-short strategy they run for our fund. In a nutshell, the firm will focus on fewer sectors where it has historically made most of its profits (resources, technology, consumer, and emerging markets), and intends to take longer-term, more-concentrated positions in its highest-conviction ideas, while running slightly lower gross exposures. We are in the process of actively assessing these changes. At quarter-end, the strategy was 91% long and 31% short, for a 60% net exposure, with the largest net long sector exposures in Internet/technology at 21%, and “MENA” (Middle East & North Africa), which consists of two positions in Saudi Arabia, at 14%.

Water Island: The Arbitrage and Event-Driven strategy produced a return of 1.1% in the first quarter. Merger Arbitrage was the best-performing sub-strategy of Water Island’s portfolio, contributing 111 bps (gross) to returns. Equity Special Situations also contributed to returns (up 59 bps), while the Credit Opportunities book detracted from returns (down 29 bps total, consisting of positive 9 bps from Merger-Related Credit and negative 38 bps from Credit Special Situations).

The top contributor in the first quarter was an Equity Special Situations investment in Conduent, the business process outsourcing business spun off from Xerox in January. Water Island established an early position on the belief that the new management team would refocus on profitability as opposed to growth at any cost. Water Island modeled and quantified the positive impact this would have on profitability at the firm and believed that a refocused Conduent traded at a material discount to peers. Having followed the situation since early 2016 (and having both short and long positions at various points throughout the year), the investment team was very familiar with the company, which allowed them to react quickly to the dislocation immediately following the spin-off from Xerox.

The largest detractor was a Credit Opportunities investment in Avaya, a privately-held, global telecommunications equipment company with troublesome leverage resulting from its 2007 leveraged buyout and 2009 acquisition of Nortel’s assets. The credit team bought Avaya’s first lien bonds significantly below their estimate of the value of the company’s businesses. However, during the first quarter the bonds drifted lower after the company filed for Chapter 11 bankruptcy while it pursued asset sales and negotiated with creditors. The bonds continue to pay interest and Water Island anticipates a reorganization plan emerging during the second quarter. They believe their low-cost basis in the bonds relative to asset value should result in a positive outcome through a variety of possible resolutions.

Entering 2017, optimism regarding the possibilities for the new administration drove market gains, but the increasing probability of ongoing Washington gridlock makes it likely that economics, corporate earnings, and corporate activity rather than politics will once again be the key factor going forward. That said, a lighter regulatory touch in the new administration has the investment team optimistic about the prospects for mergers and acquisitions (M&A) in telecommunications and financials. The overall M&A pipeline is the single largest area for opportunity they see, since it provides both speculative situations for Equity Special Situations (an area that was quite profitable last year) and Credit Opportunities, as well as announced deals for the Merger Arbitrage team.

Additional opportunities include the pipeline of spin-offs, and in Credit, long/short relative value investments (e.g., spreads in health care remain wide relative to the high-yield index) and potential deep-value credit investments (mainly focused on select names in the retail sector).

Strategy Allocations

The fund remains weighted according to our strategic target allocation: 25% each to DoubleLine and Loomis Sayles, 20% each to FPA and Water Island, and 10% to Passport. We use the fund’s daily cash flows to bring the manager allocations toward their targets when differences in shorter-term relative performance cause divergences.

Sub-Advisor Portfolio Composition as of March 31, 2017
(Exposures may not add up to total due to rounding)

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 3/31/17
Cash 15.7%
Government 1.3%
Agency Inverse Floaters 4.1%
Agency Inverse Interest-Only 5.3%
Agency CMO 6.3%
Agency PO 2.6%
Collateralized Loan Obligations 1.5%
Commercial MBS 0.9%
ABS 2.7%
High-Yield 0.2%
Municipals 3.3%
Non-Agency Residential MBS 56.1%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 3/31/17
U.S. Stocks 39.4%
Foreign Stocks 14.3%
Bonds 8.6%
Other Asset-Backed 0.6%
Limited Partnerships 0.4%
Short Sales -4.2%
Cash 41.1%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 3/31/17

Long Total
Short Total
Net Exposure
Securitized 22.6% -0.6% 22.0%
High-Yield Corporate 23.5% -4.5% 19.0%
Investment-Grade Corp. 19.0% -1.6% 17.4%
Bank Loans 5.9% 0.0% 5.9%
Dividend Equity 8.9% -5.9% 3.1%
Convertibles 1.7% 0.0% 1.7%
Global Credit 1.3% 0.0% 1.3%
Emerging Market 4.2% -3.3% 1.0%
Global Rates 49.2% -49.7% -0.5%
Currency 7.1% -10.1% -3.0%
Risk Management 0.0% 0.0% 0.0%
Subtotal
143.4%
--75.6%
67.8%
 
Cash & Equivalents
12.2%
0.0%
12.2%

 

Passport Capital Long-Short Equity Strategy
Exposures as of 3/31/17

Sector Long Short Net
Internet/Technology 29% -8% 21%
MENA 14% 0% 14%
Energy 10% 0% 10%
Financial 10% -2% 7%
Health Care 9% 0% 9%
Industrial 8% -3% 5%
Consumer Discretionary 6% -12% -5%
Consumer Staples 5% 0% 5%
Diversified 0% -6% -6%
Total 91% -56% 34%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 3/31/17

Long Short Net
Equity Merger Arbitrage 61.3% -13.7% 47.5%
Equity Special Situations 9.7% -8.2% 1.6%
Credit (Merger Related & Special Situations) 23.5% -0.1% 23.5%
Total 94.5% -22.0% 72.6%