Litman Gregory Masters Alternative Strategies Fund Third Quarter 2018 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) rose by 1.02% for the quarter ending September 30, 2018. During the same period, the Morningstar Multialternative Category returned 0.99% and 3-month LIBOR produced a gain of 0.57%. Year to date, the fund’s performance is 0.76%, while the category and LIBOR have returned negative 0.17% and positive 1.49%, respectively.

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

The fund hit its seventh anniversary at the end of the third quarter. Although seven years is an arbitrary period of time, really no more significant than six and a quarter years or eight and a half years, it is as good a time as any to reflect. We have fielded a few questions this year about the fund’s performance and why it’s below its long-term average. Performance since inception is satisfactory at 4.83% annualized, well above 3-month LIBOR (0.65%), the Bloomberg Barclays US Aggregate Bond Index (2.02%), the Morningstar peer category average (1.87%), and the HFRX Global Hedge Fund Index (1.76%), even with the relatively bland recent performance (1.43% trailing one-year gain). Given the US equity market’s astounding performance over the same time period (the Russell 1000 Index has returned 16.90% annualized!), the fund has trailed US equities by a significant margin.

We have always known, and tried to communicate to investors, that the fund wouldn’t keep up with even a conservative stock/bond mix during a strong bull market, and it would be hard to classify the past seven years as anything else other than that. Still, we are not happy about the fund’s lackluster recent performance in absolute terms. As significant investors in the fund ourselves, we want higher returns, but we are also mindful of the fund’s mandate as a lower-risk alternative, so we recognize that prudence dictates taking less risk when compensation for that risk is subpar and opportunities are generally scarce. We know that our sub-advisors are not afraid to invest more aggressively when they see attractive risk-adjusted opportunities, and in fact they welcome the chance to add exposure when others are pulling back. We have seen this recently in merger arbitrage and Puerto Rican municipal bonds, to name a couple of examples. There are others, of course, such as energy-related high-yield bonds in late 2015/early 2016 and non-agency residential mortgage-backed securities (RMBS) going back to the fund’s inception. The point is that we believe the fund is capable of generating attractive absolute performance (halfway through the fund’s life, it’s annualized return since inception was over 7%) and doing so with low volatility and low beta to the equity market.

We can’t control or predict when the markets will present opportunities, but we know that they will. In the meantime, our sub-advisors are not just sitting on cash, but actively searching for new ideas. In most cases in this environment, the types of positions they are adding demonstrate solid risk-adjusted expected returns, but not necessarily dramatic absolute return potential. This leaves less margin for error and/or bad luck, which has struck in a couple of portfolios this year to a limited degree, resulting in returns being slightly lower than they might otherwise have been this year. This is of course frustrating, but it is a part of investing. Returns rarely come in a satisfyingly smooth, upward path.

From our broad top-down view, we agree with our managers that to be very aggressive in aiming for higher returns at this point in the cycle is generally not the wisest course. We won’t run down the list of macro and geopolitical risks with which everyone is already familiar. Instead we will simply note that extremely high valuations for US stocks and loose, undiscerning credit markets, paired with rising rates and the reversal of unprecedented quantitative easing, create an environment in which one of the many known or potentially unknown risks can spark a significant dislocation in equity or credit markets. Given the balance of potential upside versus downside currently, we grudgingly accept the possibility of continued “underperformance” if markets continue their essentially uninterrupted upward march. We accept the possibility to ensure the fund adheres to its risk-managed mandate, as well as to be in position to take advantage of the future dislocations that we know will happen.

Jeffrey Gundlach was recently asked in a Forbes interview for the best financial advice he could impart. His response: “Patience is the most important thing in investing.” We believe that patience (combined with opportunism) on the part of our sub-advisors will pay off for the fund, and in turn for shareholders.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 9/30/18
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
4.83 2.02 16.9 1.87
Total Cumulative Return
39.13 15.05 198.4 13.86
Annualized Std. Deviation
3.01 2.69 10.23 3.11
Sharpe Ratio (Annualized)
1.43 0.6 1.54 0.48
Beta (to Russell 1000)
0.24 -0.02 1 0.27
Correlation of MASFX to…
1 -0.12 0.78 0.81
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
89.47% 76.32% 96.05% 80.26%
Upside Capture (vs. Russell 1000)
28.76 6.63 100 21.04
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 third quarter, four managers produced positive performance and one a minor loss. The FPA Contrarian Opportunity strategy gained 4.05%, DoubleLine’s Opportunistic Income strategy gained 0.84%, the Loomis Sayles Absolute-Return Fixed-Income strategy increased by 0.79%, and DCI’s Long-Short Credit strategy was up 0.72%. On the negative side, Water Island’s Arbitrage and Event-Driven strategy was down 0.19%. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DCI:The DCI Long-Short Credit strategy returned 0.72% in the third quarter, beginning a performance bounce-back. After gaining last year, the market environment has proved more challenging so far in 2018 and the strategy is down about 1.51% (net) year to date. By construction, the strategy remains focused on asset selection—favoring firms with lower default risk (as measured by DCI’s proprietary default probability model) and improving fundamentals. The environment this year, however, has featured a combination of low credit spreads, low volatility in credit markets generally, and the notable outperformance of lower-quality credits relative to higher quality. This set of circumstances is one of the most difficult environments for the DCI strategy.

With the credit markets strongly positive, the strategy performance was led by the long side of the portfolio, especially names in the energy sector, which outperformed on higher oil prices and improving fundamentals. Both sleeves contributed positively, and hedges performed in line with expectations. Notably, the quarter saw a big jump in interest rates, which was neutral to the portfolio as its effects were more than fully offset by the rate hedging. Credit hedging was somewhat costly but offset the tighter spreads as expected.

DCI’s proprietary credit selection models both delivered gains in the third quarter. The bond sleeve delivered modest outperformance on security selection across most of its portfolio and has now registered gains in four straight months. The market-neutral credit default swap (CDS) portfolio also delivered a positive quarter. Credit selection gains were pronounced in the energy, technology, and consumer retail sectors, with a bounce in some long energy names that had been lagging the market helping to lead the way. A relief rally in a few higher-spread low-quality short positions contributed negatively to performance. The largest positive contributors in CDS were MBIA, Chesapeake Energy, Transocean, and JC Penney, while the most negative were Avon, RR Donnelley, and Atlantia. In the bond sleeve, the largest positive contributors were long Endo International, Sirius XM Holdings, Bausch + Lomb, Match.com, and Diamondback Energy. There were no notable negative contributors.

Portfolio positioning is, as always, driven by bottom-up credit selection, and DCI continues to see attractive longs in the energy sector, against shorts in the consumer retail and banking sectors. Positioning has moved notably in a few places, following the usual model dynamics, and the portfolio is now net short names in the materials and mining sectors and net long the telecom sector (which had been a notable underweight for the past year).

DoubleLine: For the third quarter of 2018, the DoubleLine Opportunistic Income strategy’s 0.84% gain outperformed the Bloomberg Barclays US Aggregate Bond Index return of 0.02%. The US Treasury curve sold off during the quarter as 2-year and 10-year yields were up 29 basis points (bps) and 20 bps, respectively. Outperformance was therefore led by shorter-duration sectors, including both non-agency RMBS and other securitized credit. Non-agency RMBS were the largest contributors to performance due to both interest income and a small increase in prices. Subprime securities led performance within the sector. Other securitized credit sectors including collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) contributed positive performance primarily due to interest income. Prices were mostly down across this cohort, however, and CMBS led the declines.

Agency RMBS were the largest detractors from performance due to their longer-duration positioning. Inverse interest-only securities were the worst performers within the sector. Although a small allocation within the portfolio, Puerto Rico municipal bonds saw a large improvement in their prices resulting in the sector becoming one of the largest contributors to performance. Bank loans, a new sector this quarter for the portfolio, rounded out the strong performance, as prices increased across these holdings.

The portfolio’s duration increased a bit, with interest rates higher, to almost 5.1 years. Cash declined significantly from approximately 15% to under 3% of the portfolio. Although there were purchases elsewhere, the most meaningful additions were in credit sectors outside of non-agency RMBS (i.e., bank loans, CMBS, CLO, etc.), which now make up over 25% of the portfolio. Non-agency RMBS is still the largest allocation, at 52.5%.

FPA: Performance for FPA’s Contrarian Opportunity strategy was strong in the third quarter, up 4.05%. The top contributors for the quarter were Arconic, Oracle, Nexeo Solutions, United Technology, and Aon. The largest detractors were dominated by Internet companies caught up in the third quarter selloff, namely recent purchases JD.com and Facebook, as well as Baidu, which is a longer-term holding. In general, the investment team’s evolution of their view on dominant, scalable Internet/technology names has been a positive, although this quarter was more challenging. WPP and HeidelbergCement were also notable detractors. FPA added to HeidelbergCement and JD.com, as well as Lafarge and Broadcom, during the quarter.

There was a reasonable amount of activity in the quarter. New positions included a long in Mohawk, a high-quality, owner-operated flooring company doing business essentially in a duopoly that became cheap due to temporary issues related to commodity costs. Longs in Royal Bank of Scotland and Nexon are also new to the portfolio, as is a small long-Naver/short-Line pair trade, which seeks to isolate mispricing in the parent/subsidiary relationship in these Asian technology companies. The managers trimmed positions in Microsoft, Oracle, and Thermo Fisher Scientific, while reducing short positions in Tencent Holdings and Alibaba Group Holding (part of a pair trade). They sold a few positions including Cisco Systems, and a number of commodity-related businesses like Lukoil, MMC Norilsk Nickel, and Consol Energy.

The portfolio’s gross and net long exposure grew again due to net purchases, with gross long exposure now over 75% and net exposure over 65%. The largest sector concentration remains in financials, with information technology, consumer discretionary, and industrial sectors following. These four sectors account for over three-quarters of the equity portfolio. Credit holdings are approximately 4% of assets and include the Puerto Rican municipal bonds, which although a relatively small position, have been a very strong performer since FPA’s purchases last year after Hurricane Maria.

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed-Income strategy was up 0.79% during the quarter. Securitized assets, particularly ABS, non-agency RMBS, and CMBS holdings, contributed significantly to returns during the quarter as fundamentals remained stable across all sectors. Spreads narrowed very slightly during the quarter and most asset classes posted positive returns as sentiment remained optimistic. The portfolio’s highly diversified group of bank loans was also additive to returns, led by selected communications, consumer non-cyclical, and technology names. Loomis continues to view bank loans as attractive relative to other sectors, given their floating-rate nature and relative safety due to seniority in the capital structure. Even as the strategy’s exposure to high-yield has remained quite low, the allocation to bank loans remains intact. Investment-grade corporate bonds also contributed to the quarterly return as spreads narrowed. Names within the banking, consumer, and capital goods sectors were responsible for the bulk of the positive performance.

Exposure to global credits hurt performance, as positions in Argentina weakened due to the country’s continuing economic woes. Despite the high inflation and rapid currency devaluation that has marked Argentina’s economy, the country struck a deal with the International Monetary Fund to extend its line of credit by $7.1 billion in late September. Most of the negative performance among Argentine issuers can be attributed to banking names. Currency positioning also weighed on performance, mainly due to a long forward position in the Colombian peso. Most currencies continued to see weakness against the US dollar throughout the quarter. Currency markets stayed focused on the slowdown in European growth, albeit from robust levels, as the European Central Bank reaffirmed that it is on track to hit inflation targets and withdraw quantitative easing in December. As the US dollar has come back into favor, Loomis is seeking to own currencies with attractive yields and valuations, while reducing overall currency exposure.

Water Island: In the third quarter, Water Island’s Arbitrage and Event-Driven strategy was down slightly after fees. Gross of fees, the merger-arbitrage strategy of the portfolio contributed almost 80 bps to returns (with the majority coming from equity merger arbitrage, although credit-based opportunities were also positive). Credit-based special situations contributed modestly to returns, while equity special situations detracted almost 1% from performance, leading to an overall negative return of more than 80 bps for the special situations strategy.

The top contributor in the portfolio for the third quarter was an equity-merger-arbitrage investment in the acquisition of Sky by Twenty-First Century Fox. In December 2016, Twenty-First Century Fox entered into a definitive agreement to acquire Sky—a UK pay-television service operator—for $23 billion. During the first quarter of 2018, the fund benefited from a topping bid for Sky on the part of Comcast, which led to shares trading through the terms of Fox’s original offer. In addition (to make matters more complicated), Fox itself became the subject of a bidding war between Disney and Comcast. While Comcast ultimately abandoned its pursuit of Fox, it remained focused on Sky. In September, the failure to resolve the competing bids forced a rather uncommon mandatory auction process under the UK takeover code. Comcast emerged victorious, with a winning bid that was 60% greater than Fox’s original offer in December 2016, resulting in a nice gain for the portfolio.

The top detractor in the portfolio for the third quarter was an equity market hedge on the special situations strategy. From time to time, in addition to various issuer-specific hedges, Water Island may implement broader market hedges. The intent of these hedges is to reduce directional exposure and market risk, potentially reducing volatility and drawdowns in declining markets. The top deal detractor for the quarter was an equity-merger-arbitrage investment in the acquisition of NXP Semiconductors by Qualcomm. In October 2016, Qualcomm entered into a definitive agreement to acquire NXP Semiconductors for $53 billion. As of the first quarter of 2018, the deal had received regulatory approvals from all required jurisdictions apart from one: China. Approval from Chinese authorities appeared imminent when, in the second quarter, the transaction was caught in the crossfire of the ongoing trade dispute between the United States and China, with China initially refusing to approve any transactions involving the United States. Investors subsequently fled, leading to a sharp decline in NXP’s share price and driving the deal spread wider. In the third quarter, the transaction was officially terminated when, after Chinese regulators had yet to approve the deal, the parties declined to extend the merger deadline, leading to a loss for the portfolio.

Water Island’s outlook for merger arbitrage remains constructive. They believe global mergers and acquisitions (M&A) will likely continue at record levels, fueled by corporate tax cuts coupled with the repatriation of offshore cash by US companies. The team is seeing particularly aggressive activity within the Internet infrastructure, biotech/pharmaceuticals, industrials, chemicals, and consumer sectors. That said, the ongoing trade dispute between the United States and China necessitates caution regarding exposure to high-profile transactions requiring approval from China’s regulators. China has already demonstrated a willingness to reject or delay mergers for political reasons—especially in industries China deems vital to the achievement of its economic development plans (e.g., semiconductors, artificial intelligence, 5G). Water Island is also cautious toward consolidation activity in sectors that are highly concentrated or dominated by one or two large entities. Health care (HMOs) and mobile communications come to mind (e.g., T-Mobile/Sprint), as do the dominant Internet/social media companies that face increasing scrutiny from global antitrust regulators in both the United States and Europe.

Rising interest rates typically act as a tailwind for merger-arbitrage returns, producing higher-spread opportunities for arbitrageurs. The Federal Reserve has raised rates three times thus far in 2018, with a fourth bump expected in December. This has been a welcome development and the market expects several more hikes in 2019, as the Fed seeks to normalize rates in response to strong economic growth and an extremely tight labor market. While Water Island does not anticipate the rising rate environment will disrupt deal flow, they are cognizant of the risks associated with rising rates for highly leveraged deals. More broadly, today’s environment reminds them of the excesses of 2006–2007, with high levels of risk-taking on the part of financial buyers, and the team is focused on the potential risks that such excesses can bring.

In the special situations sub-strategy, the pipeline of speculative M&A opportunities has begun ramping up again following a lull of activity midyear. While the track record of the press in reporting rumored deals this year has been spotty at best, the research team continues to monitor and research these situations in the search for potential opportunities. Beyond speculative M&A, continued economic growth in the United States seems to bode well for re-rating opportunities. However, these types of catalysts are generally less definitive in nature and have longer timelines —as such, they require a heightened focus on long/short balance. Given the portfolio’s increasing allocation to re-rating opportunities, the duration of the special situations sleeve is currently skewing slightly longer compared to recent history and the portfolio managers will attempt to achieve better balance as short opportunities arise.

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 September 30, 2018
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy

Bond Portfolio Top 5 Sector Long Exposures as of 9/30/18
Energy 17.0%
Consumer Discretionary 10.4%
Technology 9.3%
General 9.3%
Media 8.1%
Total 54.1%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 80 76
Average Credit Duration (yrs.) 4.7 4.8
Spread 137 bps 142 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 9/30/18
Cash 2.5%
Government 0.0%
Agency Inverse Floaters 5.0%
Agency Inverse Interest-Only 4.2%
Agency CMO 8.2%
Agency PO 2.0%
Collateralized Loan Obligations 5.2%
Commercial MBS 6.7%
ABS 6.1%
Bank Loans 5.1%
High-Yield 0.0%
Municipals 2.5%
Non-Agency Residential MBS 52.5%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 9/30/18
US Stocks 46.6%
Foreign Stocks 25.2%
Bonds 3.7%
Other Asset-Backed 0.2%
Limited Partnerships 0.7%
Short Sales -5.8%
Exchange Traded Funds -4.2%
Cash 33.7%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 9/30/18

Long Total
Short Total
Net Exposure
Securitized 32.5% -0.5% 32.0%
Investment-Grade Corp. 21.5% -0.6% 20.9%
Bank Loans 12.7% 0.0% 12.7%
Dividend Equity 8.1% -4.8% 3.3%
High-Yield Corporate 4.6% -1.9% 2.7%
Convertibles 3.6% 0.0% 3.6%
Emerging Market 2.4% -2.7% -0.4%
Global Credit 1.2% -0.2% 1.0%
Currency 1.0% -0.4% 0.6%
Risk Management 0.0% -4.5% -4.5%
Global Rates 173.7% -36.0% 137.7%
Subtotal
261.2%
-51.6%
209.6%
 
Cash & Equivalents
8.2%
0.0%
8.2%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 9/30/18

Long Short Net
Merger Arbitrage – Equity 30.5% -8.5% 22.1%
Merger Arbitrage – Credit 11.7% 0.0% 11.7%
Total Merger-Related 42.2% -8.5% 33.8%
Special Situations – Equity 34.7% -30.8% 3.9%
Special Situations – Credit 13.0% -1.5% 11.5%
Total Special-Situations 47.7% -32.3% 15.4%
Total 89.9% -40.7% 49.2%