2017 Semi-Annual Shareholder Letter
Dear Fellow Shareholder,
The first half of 2017 proved to be another very strong period for global financial markets. In the United States, the S&P 500 Index returned 9.35%, hitting a new all-time high in late June. Smaller-cap stocks, represented by the Russell 2000 Index, gained 4.99%. Foreign stock markets did even better during the period, with the MSCI EAFE Index of developed international markets rising 13.80% (in U.S. dollar terms) and the MSCI Emerging Markets Index up 18.43%. However, both indexes remain well below their all-time highs, reached prior to the financial crisis of 2008.
Core investment-grade bonds also delivered solid returns in the first half of the year. The Bloomberg Barclays U.S. Aggregate Bond Index was up 2.28%, as the benchmark 10-year Treasury yield declined. However, shorter-term Treasury yields rose during the period (as the Federal Reserve raised rates twice), causing the yield curve to flatten considerably, with the difference between the 10-year and 2-year Treasury yields ending the second quarter at close to a post-2008 low.
For the first half of the year, the Litman Gregory Masters International Fund outperformed its benchmarks with a strong 14.83% return. The Litman Gregory Masters Equity Fund and Litman Gregory Masters Smaller Companies Fund both generated solid absolute returns but trailed their benchmarks. The Litman Gregory Alternative Strategies Fund performed in line with its absolute risk and return objectives. It continues to have the highest risk-adjusted return (as measured by both the Sharpe and Sortino ratios) in its Morningstar category, since inception.
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.
Thoughts on the Bigger Picture
As we look back over the first half of the year, one of the most notable items is how steadily markets have risen, despite ongoing political uncertainty, geopolitical tumult, and central bank activity. As has been widely reported, the VIX index—an indicator of expected short-term stock market volatility—fell to a 23-year low in the second quarter and an all-time low in late July. What’s more, the S&P 500’s actual volatility has fallen to among its lowest levels in the past 50 years. We believe the very low volatility together with historically high U.S. stock market valuations reflects a broad complacency among equity investors, particularly in light of an unusually uncertain and potentially quite volatile macro backdrop. From our top-down view looking at the U.S. market in aggregate, we believe valuation risk is high, offering little margin of safety in the event of an unpleasant macro surprise or an economic slowdown.
That said, maintaining a degree of equanimity is a valuable attribute of successful long-term investors and we’d distinguish it from complacency. Global risks always exist and unexpected events inevitably happen, causing markets to fall no matter their valuation. The world and financial markets have faced numerous negative shocks over the decades, but the broad economic impacts have ultimately proved transitory. Over the long term, financial assets are priced and valued based on their underlying economic fundamentals—yields, earnings, growth—not on transitory macroeconomic or political events. Therefore, we believe it is beneficial for investors not to react to every unpleasant news headline with the urge to sell their stocks, nor to get overly excited and jump into the market based on some piece of news they view positively. Refraining from such short-term trading is not being complacent, as long as it is supported by a sound decision-making framework, a disciplined investment process, and a consistent focus on one’s long-term financial objectives.
Thoughts on the Funds
We want to reiterate that Litman Gregory’s market and asset class views have no bearing on the Masters equity funds. The funds’ positioning and exposures are entirely the result of the stock selection and investment decisions of the funds’ sub-advisors. But we’d also note that a few of the managers on both our domestic Equity and Smaller Companies funds have been finding it challenging to identify compelling new investment ideas for their Masters portfolios due to expensive (and rising) stock prices and unattractive return potential. This includes Nuance Investments on the Equity Fund and SBH, the new sub-advisor we added to the Smaller Companies Fund in June. (Please see our full write-up on SBH.)
Moving to international stocks, our top-down outlook for them is much more positive than for U.S. stocks, given their more attractive valuations and earnings growth potential, even after their strong performance in the first half of this year. This view is broadly shared by our International Fund sub-advisors, particularly with respect to the stock-picking opportunities in Europe. Reflecting this, at quarter-end our International Fund had a 74% weighting in European stocks—a meaningful overweight compared to the MSCI ACWI (ex-U.S.) benchmark’s 45% allocation. We are also excited to have added David Marcus, founder of Evermore Global Advisors, as a new sub-advisor to the fund at the end of the first quarter. Marcus is finding many misunderstood “special situations” (e.g., companies undergoing restructuring) in Europe that are trading at deep discounts to his estimate of intrinsic value and where he sees catalysts to unlock that value.
Finally, turning to the Alternative Strategies Fund, we are very enthusiastic about adding DCI as a sixth sub-advisor on the fund in early July. DCI is a San Francisco-based, corporate credit-focused investment firm that manages systematic, quantitatively-driven strategies. DCI will run an absolute-return-oriented, long-short credit portfolio for our fund. We believe DCI’s strategy can generate attractive risk-adjusted returns across a variety of market environments, with low volatility, low risk of significant drawdowns, and low or no correlation to the equity, credit, and Treasury bond markets. (Please see our full write-up on DCI.)
More broadly, given our base case expectation of very low returns for the U.S. stock and bond markets over the next several years, we continue to see strong potential for the Alternative Strategies Fund to improve a traditional balanced portfolio’s risk-return profile. While there has seemed to be little need for diversified portfolios over the last eight years of a raging U.S. equity bull market, history teaches that this cycle will turn too, and the portfolio benefits of alternative strategies, and international stocks as well, will be apparent.
As always, we thank you for your confidence in the Litman Gregory Masters Funds. Our commitment and confidence is reflected in the collective personal investments in the funds by Litman Gregory principals, employees, and the funds’ trustees of over $21 million, as of June 30, 2017.
Jeremy DeGroot, President and Portfolio Manager
Jack Chee, Portfolio Manager
Rajat Jain, Portfolio Manager