Q&A with Litman Gregory Chief Investment Officer and Fund Portfolio Manager Jeremy DeGroot
The Litman Gregory Alternative Strategies Fund reached its five-year anniversary on September 30, 2016. When we launched the fund just over five years ago, we conducted a Q&A with Litman Gregory co-founder Ken Gregory and chief investment officer and fund portfolio manager Jeremy DeGroot to talk about our views on the alternatives landscape and the basis for coming out with our own fund. We thought it would be helpful to investors considering alternatives in general, and our fund in particular, to check in with Jeremy now, roughly five years later.
Performance data 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 fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.mastersfunds.com/alt. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The popularity of alternatives funds, including multistrategy alternatives funds, surged in recent years, but more recently interest has waned. How do you see the challenges for fund investors in the alternatives space?
It is a challenging category for the reasons we outlined five years ago when we launched our fund. Fees are often egregiously high, the quality of the managers is often questionable, strategies are sometimes not understandable or well explained, and portfolio construction for multimanager funds is sometimes marketing driven rather than investment driven. So the result has been mediocre performance and investor disappointment. The challenge is to identify funds that charge reasonable fees, provide access to highly skilled managers, and deliver intelligent portfolio construction.
The Alternative Strategies Fund now has a five-year record, and it has achieved the best risk-adjusted performance in its category based on Sharpe ratio. It also has a Five-Star Overall Morningstar RatingTM, which is also based on risk-adjusted performance. Is strong risk-adjusted performance your primary focus?
In creating this fund, we sought to build a core, lower-risk alternatives portfolio that would hold up well in equity bear markets and exhibit relatively low correlation and beta to stocks and bonds, while still being able to deliver solid long-term performance in absolute terms. There are several things we focus on, but certainly risk-adjusted performance is a primary one.
Are you happy with how the fund has performed relative to all these objectives?
Overall, we’re pleased. We finished our first five years with a Morningstar Five-Star Overall RatingTM. The fund’s volatility was below the range we targeted. As of June 30, 2017, absolute returns were healthy at 5.41%. Our stock market beta was very low at 0.25 and our correlation relative to the bond market was negative.
The only metric for which we didn’t at least meet our goals was our correlation to stocks, which came in at 0.79. But we explicitly stated at the time of our launch that we expected our correlation to vary over time (given our managers’ opportunistic approaches) and at times come in above our target level. The fact that U.S. stocks had much higher returns than other asset classes during this period probably explains the higher correlation. It is worth noting that the fund’s correlation to stocks was lower in down market periods, which is ideally what we want. We do have some stock market exposure but not a lot, which helps explain our very low stock market beta.
Were there surprises?
I’d say we were mildly surprised by the fund’s slightly negative correlation to bonds. That was probably a big surprise to some investors who assumed the fund would have a higher correlation since two of our sub-advisors are fixed-income investors. However, their approaches to fixed-income are quite flexible with respect to the kinds of credit risk they can take, their management of portfolio duration (interest rate risk), and their ability to take on currency risk. So we expect their performance to be quite different than the investment-grade bond market. And the overall portfolio diversification we get from the other sub-advisors reinforces that result.
The fund’s return exceeded the 3-month LIBOR, and was very strong relative to its Barclays U.S. Aggregate Bond Index benchmark. Yet the returns paled in comparison to stocks and also trailed a balanced benchmark. Was that disappointing?
Of course, we would always like to perform well relative to all mainstream asset classes. But that isn’t realistic. When we launched the fund, we warned that very-high-return periods for stocks would be a challenge for relative performance, especially compared to benchmarks that include meaningful stock exposure. As of June 30 2017, the Russell 1000 Index is up over 16% annualized. Since our fund is not designed to have sizable stock exposure, and it also has a heavy focus on risk aversion, this was a very tough period in which to compete.
It’s our view, and one shared by our sub-advisors, that the U.S. stock market is significantly overvalued. It’s been inflated by microscopically low interest rates rather than strong fundamentals. Many countries' government bonds are trading with negative yields. Clearly these levels don’t make sense over the long run, and we don’t expect them to be sustained. Yet stocks have moved higher over the past five years even though earnings growth has barely been positive over that time period. Low interest rates have effectively forced investors to take more risk. This has had a particularly strong impact on the U.S. stock market, which has experienced a sizable rise in price-to-earnings ratios, to the extent that, on many measures, they are at levels that preceded major market downturns in the past. Since our managers have a risk-averse mindset, they won’t chase overvalued securities or markets.
The bottom line is we believe our managers are staying true to the risk-management focus of this fund. The last five years could be setting them up for much stronger relative performance over the next five years if markets become more focused on fundamentals. History strongly suggests markets eventually come back to fundamentals and reality.
Has your view of the fund’s role within a portfolio changed over the past five years?
It hasn’t changed. We still view it as a core, all-weather fund, appropriate for part or all of the alternatives exposure in a diversified portfolio. And we think a reasonable rule of thumb for funding the position can be 20%–40% from stocks and 60%–80% from bonds. As noted above, it has been challenging to compete against such a stock/bond blend over the past five years because of extremely high U.S. stock returns. But looking forward, with bond yields even lower than they were five years ago and stocks quite overvalued in our view, we believe the fund is very well positioned to add value.
We also would reiterate that, though tempting, we would not recommend funding the entire position out of investment-grade bonds, though a meaningful portion can be funded from that asset class. We believe our fund will, at times, outperform bonds when stocks are weak, and we believe long-term returns should stack up very well versus bonds. But in recessionary bear markets, we believe bonds still offer important diversification value, in spite of their very low yields.
Do investors need alternatives exposure?
We don’t think investors need an alternatives fund. Fund investors have a wide range of asset classes at their disposal to build a well-diversified portfolio. Whether an investor includes alternatives in their portfolio should depend on the quality and the approach of the fund and the likelihood of it adding to the risk-adjusted performance of the overall portfolio. We do believe there are highly skilled managers in the alternatives world. If they can be accessed at a reasonable fee and combined in a way that can smooth out performance, in our view, they can improve a portfolio’s risk-adjusted returns. Doing all those things is a challenge, and the approach we took in building our fund was to address each key component of success. Going forward, there are plenty of reasons to look beyond the standard asset classes given extremely low bond yields and what we believe is a quite overvalued U.S. stock market. In this context, we believe our fund is very well positioned.
You make the case that the quality of alternatives managers is extremely important. How do you pick your sub-advisors?
We spend an enormous amount of time with potential sub-advisors to gain a deep understanding of their investment process, their skill in executing that process, their intellectual fire power, and the quality of their team and organization. We need to understand what drove past performance success and why they made mistakes. At the end of the day we need to feel very confident that the sub-advisor has an edge that is understandable and sustainable. We’re exceptionally thorough, and we have a very demanding standard that leads us to walk away if we can’t get to a high level of conviction.
Do you expect to add new sub-advisors to the fund?
We’ve added two sub-advisors so far (to our original lineup). Over time, it’s possible we will continue to gradually grow the group. This assumes we can find sub-advisors that meet our very high due diligence standards, who we believe are additive to the overall portfolio’s risk-return profile, and whose fees enable us to keep overall fund expenses at a very competitive level.
What final thoughts would you like to share with someone evaluating this fund?
We created this fund because we couldn’t find high-quality options in the marketplace. Fees were too high and management quality was often mediocre. And there was another problem. We felt that marketing considerations were coming before investment considerations in the structuring of many funds. Funds were being designed with fancy strategies to seem sexier and smarter. We believed the only way to build a successful fund was to combine skilled managers and a reasonable fee level. And we focused on the investment outcome, believing that if we could achieve a good outcome eventually marketing would take care of itself.
Part of that focus was to identify managers who we believe have a risk-averse mindset and take that seriously, but who are also willing to opportunistically ratchet up the risk level somewhat when the reward to risk is particularly compelling. If done well, we believe this is a way, over the long run, to attempt to capture good returns while also mitigating against large drawdowns. One thing we didn’t focus on was seeking out highly complex strategies just for the sake of having them. And in the early days, our fund was sometimes criticized for not being “alternative enough.” But five years out, the fund’s performance is on target to reach the long-term outcome we hoped for and in line with what we believe investors are looking for in an alternatives fund. We believe this approach will continue to work well and that the next five years could be even better relative to our competition and mainstream asset classes.
The continued success of this fund is extremely important to Litman Gregory and we are focused on achieving our objectives. This confidence is also reflected in our sizable personal investments in the fund.
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