Litman Gregory Masters Alternative Strategies Fund First Quarter 2018 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) declined 0.24% in the first quarter of 2018.i During the same period, the Morningstar Multialternative Category was down 1.10% and 3-month LIBOR returned 0.32%.

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

Much has been said and written, both by managers and the financial media, about the low volatility environment that has been pervasive for much of the last five-plus years. Market activity in the first quarter finally put an end to that, with the Chicago Board Options Exchange Volatility Index (the VIX), the most commonly used market measure of equity volatility, rising from about 10 at the start of the year to 37 at its peak closing value and ending the quarter in the low 20s. Even more dramatic was the fact that the VIX more than doubled in one day in early February, effectively putting some short-volatility players out of business.

Despite this drama, in addition to the now almost routine domestic political chaos and threats of wars (of both the nuclear and trade varieties), the U.S. stock market ended the quarter down less than 1%. From an end-to-end perspective, ho-hum. However, looking intraquarter we see a correction of over 10%. Further, the core bond index finished the quarter down almost 1.5%, a significant quarterly decline for traditionally low-risk assets. This is perhaps unsurprising given the specter of rising rates that many investors have been expecting for years is finally upon us and might be a significant risk factor for some time going forward.

Against this backdrop, we are satisfied with the fund’s performance during the quarter, preserving capital effectively while preparing for what we think is likely to be a different investing environment going forward. The removal of quantitative easing and higher short-term interest rates seem very likely to remove some of the “safety net” that markets have enjoyed since the financial crisis. Additionally, new Federal Reserve chair Jerome Powell seems to be at least marginally less sympathetic to capital markets than his recent predecessors when considering the course of monetary policy. Overall, our sub-advisors remain relatively defensively positioned within their strategies.

Ultimately, we and our sub-advisors welcome a more “normal,” somewhat higher volatility regime, which should allow risk to be priced appropriately and encourage the market to differentiate between good and bad stocks, credits, merger deals, etc. The path from ultra-low rates and volatility to “normalcy” was never likely to be smooth, and it has already produced some dramatic losses, but we think it will be healthy for markets in the long term. Volatility more akin to long-term averages and higher interest rates should help our managers generate good performance, albeit with a higher standard deviation of returns than we’ve experienced since inception. Avoiding land mines like the short-volatility trade unwind and generating reasonable returns along the way will be key to success in this migration. We believe the quality of our sub-advisors, the complementary nature of the different strategies they manage, and the flexible mandate of the fund provide an advantage in navigating the path ahead.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 3/31/18
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
5.05 2.20 16.39 1.87
Total Cumulative Return
37.76 15.21 168.22 12.80
Annualized Std. Deviation
3.10 2.74 10.53 3.22
Sharpe Ratio (Annualized)
1.51 0.70 1.47 0.50
Beta (to Russell 1000)
0.25 -0.02 1.00 0.27
Correlation of MASFX to…
1.00 -0.12 0.79 0.82
Worst Drawdown
-6.94 -4.52 -12.41 -8.21
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.08
% Positive 12-Month Periods
88.57 82.86 95.71 78.57
Upside Capture (vs. Russell 1000)
30.16 7.20 100 21.92
Downside Capture (vs. Russell 1000)
26.68 -6.68 100 41.95
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 quarter, two of five sub-advisors produced positive returns, one was essentially flat, and two were negative (all net of the management fee charged to the fund). DoubleLine’s Opportunistic Income strategy produced a gain of 0.98% and the Loomis Sayles Absolute-Return Fixed-Income strategy was up 0.85%. Water Island’s Arbitrage and Event-Driven strategy lost 0.02%, FPA’s Contrarian Opportunity strategy was down 0.99%, and DCI’s Long-Short Credit strategy declined 1.33%

Key performance drivers and positioning by strategy

DCI: DCI’s Long-Short Credit strategy declined 1.33% during the quarter. Performance was marked by a sharp retrenchment as broadly positive January results reversed across the board in February and continued to slide in March. The negative result was driven by widespread weak asset-level results across the two strategy sleeves, but especially in the corporate bond portfolio.

Over the quarter, the long/short credit default swap (CDS) sleeve was down about 25 basis points (bps) while the bond sleeve was down about 100 bps, with bond losses split about 65 bps owing to credit spreads and about 35 bps due to rates. Beta hedges contributed positively, as rates jumped higher and spreads were about unchanged on net. The 10-year U.S. Treasury yield ended the quarter about 30 bps higher, while the two-year soared by nearly 40 bps. Because DCI hedges duration in the portfolio to about 1.5 years, the move at the short end left some residual losses.

Although gains and losses were mostly offsetting between longs and shorts and across sectors, the CDS sleeve contributed a modest net loss overall. Positive performance from asset selection in the technology, transportation, insurance, and utilities sectors was more than offset by losses from within the consumer, hospitals, media, and homebuilder sectors. The biggest gainers were MBIA, Xerox, Bombardier, Macy’s, and U.S. Steel. The biggest losers were Avon, RR Donnelley, Tenet Healthcare, Nabors, and Viacom.

The strategy’s bond sleeve suffered from poor asset selection amidst market headwinds. Investors aggressively sold cash bonds in February and March as spreads widened. The market paid little heed to fundamentals and broadly sold bonds characterized by liquidity, quality, and recent strong performance. This is consistent with significant outflows from corporate bond funds and worked against DCI’s fundamentally driven credit selection. Losses in the portfolio were widespread rather than deep, as names within the consumer goods, media, and technology sectors particularly contributed to the losses, while the transportation and mining sectors were positive. The bond portfolio’s credit hedge overdelivered for the quarter relative to expectations, despite being a drag in March when credit derivative spreads did not widen in line with cash instruments.

DoubleLine: In the first quarter, the DoubleLine Opportunistic Income portfolio’s 0.98% gain outperformed the Bloomberg Barclays U.S. Aggregate Bond Index’s negative 1.5% return. The U.S. Treasury curve flattened during the period as the 2-year and 10-year yields were up 38 bps and 33 bps, respectively. Interest rate–sensitive agency residential mortgage-backed securities (RMBS) were the largest detractors from performance due to the rate selloff, and inverse interest-only securities were the worst performers within the sector. Non-agency RMBS contributed positive total return due to interest income. Alt-A securities were the best performers within the sector while prime-backed bonds underperformed as prices declined. Other securitized credit sectors including collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) also contributed positive total return due to interest income. Puerto Rico municipals were large contributors to performance after prices increased materially due to higher government projections for economic recovery. The Puerto Rican bonds remain a small (~2%) part of the portfolio.

DoubleLine remains defensively positioned, with 13% of the portfolio remaining in cash, awaiting more favorable opportunities to deploy capital. Non-agency RMBS remains the largest sector allocation at approximately 57% (with almost 60% of that in bonds backed by Alt-A collateral), which still offers relatively attractive risk-adjusted returns, though without the significant absolute upside it did a number of years ago. Agency mortgage bonds still make up about 18% of the portfolio, with the majority of that allocation representing longer-duration holdings that account for most of the strategy’s overall rate sensitivity. The portfolio ended the quarter with a calculated duration of 4.9 years and a yield to maturity of 4.0%.

FPA: FPA’s Contrarian Opportunity strategy lost 0.99% in the quarter. The recently established Puerto Rico municipal bond positions, though small (<2%), were quite profitable during the quarter. Other top contributors were blue chip tech names Cisco Systems, Microsoft, TE Connectivity, and Nexeo Solutions. The largest detractors were the Naspers/Tencent pair trade, Arconic, and financial companies Leucadia, AIG, and Citigroup. FPA added to both AIG and the Puerto Rico position during the quarter.

The portfolio’s gross long exposure to equities remains at approximately 68%, with 21% in foreign stocks. However, net equity exposure is only 56% due to a number of pair trades (e.g. Naspers/Tencent, Altaba/Alibaba), hedges, and small single-name shorts. Credit holdings are 6% of assets. Financials remains the largest sector concentration at approximately 20%. Technology maintains its place as the second-biggest sector exposure, climbing to 14%. FPA added a new position in Facebook on its price weakness, consistent with the portfolio managers’ desire to own higher-quality companies but reluctance to pay “full price” for them. Other new positions include a PG&E (long)/Utilities Select Sector SPDR ETF (short) pair trade, Kinder Morgan (long), and participation in a rescue loan to a sports-related real estate development. The portfolio’s cash position grew modestly to 37%.

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed-Income strategy returned 0.85% during the first quarter. Global rates positions (primarily sovereign bonds, interest rate swaps, and futures) contributed positively to performance. Exposure to South African sovereign bonds had the largest impact, as investor sentiment in the country improved dramatically following the resignation of former president Jacob Zuma and the election of his successor, Cyril Ramaphosa. President Ramaphosa is expected to reform the government and rein in the rampant corruption that dominated Zuma's time in office. Additionally, short positions in Eurodollar, U.K. Gilt, and U.S. interest rate futures generated positive performance as yields in these regions rose due to the ongoing tightening monetary policies at both the Bank of England and the Fed. Securitized assets, particularly non-agency RMBS and ABS, contributed to performance during the quarter as fundamentals remained stable across all sectors and spreads continued to tighten.

Equities also added to performance amid continued strength from stock markets around the world during January. Much of the positive impact can be attributed to positions in individual energy names. Additionally, short exposures and options strategies designed to limit equity risk in the portfolio provided some protection as volatility picked up in February. Equities have pulled back significantly since January, but the portfolio managers remain constructive on the strategy’s holdings, while also maintaining hedges equivalent to about half of long exposure in order to manage downside risk.

The portfolio’s diversified group of bank loans also bolstered performance. Select communications, technology, and consumer non-cyclical names contributed the most to performance. Bank loans’ floating-rate nature and relative safety (given their senior position in the capital structure) are attractive features, and the sector continues to draw investor interest. Loomis has continued reducing exposure to high-yield, but the allocation to bank loans remains intact.

Emerging-market exposure produced the most significant negative returns of any sector during the quarter (although only costing the portfolio <0.2%), ending a solid streak of positive returns from last year. Higher inflation expectations and the reality that central banks will not be accommodative forever overshadowed the current environment of synchronized global growth, leading to the market’s perception of increased risk. Exposure to consumer non-cyclical, energy, and basic industry spaces weighed on return the most.

Water Island: The Arbitrage and Event-Driven strategy was effectively flat net of fees in the first quarter. The merger-arbitrage segment of the portfolio contributed more than 41 bps (gross) to returns, comprising 38 bps from equity merger arbitrage and 3 bps from credit-based opportunities. Credit-based special situations also contributed to returns (positive 35 bps), though equity special situations detracted 35 bps from returns, resulting in flat performance for the special situations sleeve.

The top contributor in the portfolio was the equity market hedge, which fulfilled its intended purpose in helping to mitigate the adverse effects of the severe volatility, which roiled the markets during the first quarter. The top deal contributor in the portfolio was an equity merger-arbitrage investment in Twenty-First Century Fox’s planned acquisition of Sky. In December 2016, Fox entered into a definitive agreement to acquire Sky (a U.K. pay-television operator) for $23 billion. During the first quarter of 2018, the fund benefited from a topping bid for Sky by Comcast, which led to shares trading through the terms of Fox’s original offer. Spreads remain elevated on the expectation that Fox will increase its offer (it is working with Disney on a divestiture package that would include Sky News, which helps to underscore its commitment). Water Island is maintaining the position in anticipation of more clarity in the second quarter.

The top detractor in the portfolio was an equity special situations investment in CDK Global. CDK Global is a U.S. information technology company providing inventory management software and digital marketing solutions to the automotive retail industry. Over the past year, the company has been the focus of activist interest, which culminated in the launch of a sale process late last year. After initially passing on the idea, the portfolio managers subsequently purchased CDK in February after public reporting detailed that private equity bidders were nearing a deal to acquire CDK for over $10 billion, which lined up with Water Island’s leveraged buyout valuation. Unfortunately, potential buyers seem to have abandoned their pursuit after CDK stock significantly outperformed the market based on the buyout speculation. With CDK stock now having retraced those gains, Water Island expects buyers to come back to the negotiating table. Speculative mergers and acquisitions (M&A) positions, which had been quite profitable last year, detracted from returns during the quarter. Aside from speculative M&A, the special situations team is focusing on maintaining long/short balance in the sleeve. This served the portfolio well, as a number of the alpha short positions helped offset losses amidst the quarter’s volatility.

Following a year of historically low volatility, the market exhibited significantly higher uncertainty in the first quarter of 2018. This volatility reflects a recalibration of market valuations with respect to a number of factors, including the removal of the Fed’s quantitative easing policies, higher short-term interest rates, steady economic growth, higher potential inflation, and potential trade wars. The event-driven landscape was not immune to the effects of the quarter’s volatility spikes, and much of the portfolio’s gains through the first two months of the year were given back in March. Despite these uncertainties, Water Island remains particularly constructive on the merger-arbitrage strategy. Average deal spreads—and thus return potential for the merger-arbitrage strategy—have widened considerably compared to the levels experienced over the past few years, due largely to favorable conditions for all three of the primary drivers of merger-arbitrage returns: volatility has returned, interest rates are on the rise, and deal flow is healthy. As such, the firm anticipates sizing the merger-arbitrage segment of the portfolio closer to the higher end of its expected range in the near term.

Strategy Allocations

The fund’s capital is allocated according to its strategic target allocations: 25% to DoubleLine, 19% each to DCI, Loomis Sayles, and Water Island, and 18% to FPA. 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, 2018
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy

Bond Portfolio Top Ten Sector Long Exposures as of 3/31/18
Consumer Discretionary 14.3%
Energy 13.4%
Materials 8.5%
Technology 8.4%
General 7.3%
Media 6.8%
Transportation 4.4%
Financials 3.5%
Consumer Non-Discretionary 3.4%
Investment Vehicles / REITs 3.2%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 83 69
Average Credit Duration (yrs.) 4.7 4.8
Spread 136 bps 155 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 3/31/18
Cash 13.2%
Government 1.1%
Agency Inverse Floaters 5.2%
Agency Inverse Interest-Only 3.0%
Agency CMO 8.3%
Agency PO 2.1%
Collateralized Loan Obligations 1.5%
Commercial MBS 1.9%
ABS 5.0%
High-Yield 0.1%
Municipals 2.0%
Non-Agency Residential MBS 56.6%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 3/31/18
U.S. Stocks 43.4%
Foreign Stocks 24.5%
Bonds 6.2%
Other Asset-Backed 0.4%
Limited Partnerships 0.5%
ETFs -2.8%
Short Sales -9.0%
Cash 36.8%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 3/31/18

Long Total
Short Total
Net Exposure
Securitized 28.3% -0.7% 27.6%
Bank Loans 10.8% 0.0% 10.8%
Investment-Grade Corp. 10.2% -0.4% 9.8%
Dividend Equity 8.6% -4.1% 4.5%
High-Yield Corporate 7.9% -1.8% 6.1%
Currency 7.1% -12.7% -5.6%
Emerging Market 6.6% -3.7% 2.9%
Convertibles 3.2% 0.0% 3.2%
Risk Management 1.7% -2.8% -1.1%
Global Credit 1.3% 0.0% 1.3%
Global Rates 90.1% -21.4% 68.7%
Subtotal
175.7%
-47.6%
128.2%
 
Cash & Equivalents
16.2%
0.0%
16.2%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 3/31/18

Long Short Net
Merger Arbitrage – Equity 78.3% -18.0% 60.3%
Merger Arbitrage – Credit 7.8% 0.0% 7.8%
Special Situations – Equity 30.0% -21.9% 8.2%
Special Situations – Credit 1.5% -1.8% -0.3%
Total 117.6% -41.7% 75.9%