Litman Gregory Masters Alternative Strategies Fund First Quarter 2019 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 3.94% in the first quarter of 2019. During the same period, the Morningstar Multialternative Category was up 4.06% and 3-month LIBOR returned 0.70%.

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 rebounded sharply from losses at the end of 2018, gaining nearly 4%, with all five subadvisors contributing positive performance. Just as we would caution investors not to give too much weight to short-term negative performance like that experienced in the fourth quarter of last year, we similarly advise discounting strong short-term results like those of Q1. We are gratified to see many of the moves our subadvisors made during last year’s market turbulence pay off; as we have always tried to stress, investing opportunistically when prices, yields and spreads are attractive is a key part of the fund’s value proposition.

Examples include DoubleLine shifting over 10 percentage points of its portfolio from cash into credit sectors outside of non-Agency RMBS (which continues to be their largest allocation); FPA initiating or adding to positions in beaten-down financials, tech names, and a commodity-related position; and Loomis Sayles opportunistically buying high-yield bonds, increasing the net allocation from almost nothing to the low teens over the course of the fourth quarter, helping to increase the yield on its portfolio by over one percentage point while keeping duration largely unchanged. Water Island also increased gross long and net exposure significantly in the fourth quarter into a better spread environment, at the same time increasing the proportion of hard-catalyst, lower-volatility, merger-related positions. All of these moves produced positive results in Q1, although to be fair, there wasn’t much that didn’t work during the quarter aside from outright short positioning in risk assets. (DCI, given the systematic nature of their strategy, does not have the opportunity to make as significant “active” decisions, although the strategy did experience good performance in the quarter. This was driven by both positive alpha contribution from their credit selection models as well as a reversal of the asset flow-driven dynamics that negatively impacted the long bonds/short CDX portion of their portfolio late last year.)

While it always feels good to get the validation of positive returns, we are slightly disappointed at the speed and magnitude of the rebounds in equity and credit markets, since the opportunity set for our managers has once again become less attractive. However, we must play the cards we are dealt by the markets, which for now means our subadvisors are remaining disciplined and fairly conservatively positioned, but willing and able to invest more aggressively when the time comes.

The ability to deploy capital into various market dislocations when they occur should produce attractive absolute returns over time, although these “fat pitches” are episodic and can disappear quickly. However, by capturing more of the upside than downside of equity and credit market moves and adding value through sector/security selection, remaining neutral to the direction of interest rates, and harvesting returns from idiosyncratic events, we expect to consistently generate strong risk-adjusted returns.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 3/31/19
 
MASFX
Bloomberg Barclays Agg Bond
Morningstar Multi-Alternatives Category
HFRX Global Hedge Fund
Russell 1000
Annualized Return
4.64 2.50 1.65 1.22 15.42
Total Cumulative Return
40.55 20.38 13.03 9.49 193.17
Annualized Std. Deviation
3.18 2.79 3.39 3.70 11.37
Sharpe Ratio (Annualized)
1.26 0.70 0.33 0.19 1.27
Beta (to Russell 1000)
0.24 -0.02 0.27 0.27 1.00
Correlation of MASFX to…
1.00 -0.12 0.81 -0.01 0.79
Worst Drawdown
-6.94 -4.52 -8.21 -8.97 -17.42
Worst 12-Month Return
-4.49 -2.47 -6.08 -8.19 -7.21
% Positive 12-Month Periods
85.37% 75.61% 75.61% 69.51% 93.90%
Upside Capture (vs. Russell 1000)
28.56 8.04 21.41 20.40 100.00
Downside Capture (vs. Russell 1000)
24.58 -6.56 38.39 40.48 100.00
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, all five subadvisors produced positive returns. FPA’s Contrarian Opportunity strategy was up 10.67%, DoubleLine’s Opportunistic Income strategy gained of 3.39%, the DCI Long-Short Credit strategy increased by 2.49%, the Loomis Sayles Absolute-Return Fixed Income strategy was up 2.39%, and Water Island’s Arbitrage and Event-Driven strategy returned 2.07%. (All returns are net of the management fee charged to the fund.)

Key performance drivers and positioning by strategy

DCI: The DCI Long-Short Credit strategy returned 2.5% in Q1, bouncing back from a poor Q4, led by strong alpha across the board and a boost from credit hedging and from residual rates exposure (the strategy’s duration target is roughly 1.5 years). 2019 has so far been marked by a strong credit-market rally as the market recovered from the year-end fear-driven sell-off and with a renewed focus on credit-fundamentals. Unlike the disparate market cross-currents of 2018, this environment has been positive for DCI’s credit-selection models, with both the CDS and bond portfolios delivering positive alpha. Residual exposure to betas was also a positive contributor, with gains from both credit and rates. Credit hedging on net contributed positively in the first part of the quarter, making up much of its underperformance from Q4, as cash bonds eventually rallied more than the derivative index. Rates made a net positive contribution throughout the quarter amidst the strong government bond rally. By design the portfolio construction is always focused on asset selection – favoring firms with lower default risk (as measured by DCI’s proprietary default probability model) and improving fundamentals – and is designed with low exposure to market factors.

Security-selection gains were notably positive in both the CDS and bond portfolios, fueled by investments in consumer durables, healthcare, technology, and media names, with some offset from selection in banks, materials, and energy names. Gains were strongest in the bond portfolio, led by long positions in homebuilders, REITS, consumer goods, healthcare, and media. Positioning moved over the quarter to be neutral on energy names, more favorable within media and equipment, and less favorable on technology credits. However, the main portfolio themes remained in place, with the bottom-up credit selection model continuing to see attractive short positions in banks, energy, and materials, against longs in utilities, consumer durables, media, pharma, and insurance. As always, the credit selection favors improving fundamentals and strong credit quality.

DoubleLine: For the first quarter of 2019, the Opportunistic Income strategy returned 3.4%, outperforming the Bloomberg Barclays Aggregate Bond Index. The outperformance was due to duration positioning and security selection within Agency residential mortgage-backed securities (Agency MBS). The portfolio’s Agency MBS exposure is primarily composed of Agency derivative positions such as inverse floating rate securities, which exhibit longer duration profiles compared with the passthroughs in the index. These longer duration securities benefited from the rate rally as 2-year and 10-year U.S. Treasury yields were down 23 basis points (bps) and 28 bps, respectively. Therefore, Agency MBS were the largest contributors to performance. Collateralized loan obligations (CLOs) led returns on the credit side as prices increased. Non-Agency residential mortgage-backed securities (Non-Agency RMBS) and asset-backed securities (ABS) were also accretive to performance due to both interest income and an increase in prices. Commercial mortgage-backed securities (CMBS) were the only sector to detract from performance as prices declined. Non-securitized credit sectors (bank loans and Puerto Rico municipal bonds) rounded out the strong performance this quarter as both sectors saw prices increase. The portfolio ended the quarter with a calculated duration of 5.1 years and a yield to maturity of 5.0%.

FPA: FPA’s Contrarian Opportunity strategy bounced back from its difficult Q4 2018 with a strong 10.7% gain. The top contributors for the quarter were largely internet or technology companies that rebounded from the sharp sell-off at the end of 2018, including Altaba, Analog Devices, Broadcom, Alphabet, and United Technologies. The largest detractor was the PG&E (long)/Utilities Sector (hedge) position, which has been a very poor performer since the managers initially invested in PG&E in Q1 2018 at what seemed like a favorable valuation following the stock’s significant drop in the months after the Northern California wildfires in the fall of 2017. More fires followed in 2018 and the company filed for bankruptcy protection early in 2019 amid uncertainty around its ultimate liability exposure. The stock has rallied from its lows in January, and subsequent to quarter end, as there has been news regarding possible state aid for the company. FPA trimmed exposure during the quarter. Other detractors included Univar (received after Univar purchased Nexeo Solutions, which the fund held), GE, and OSX3 Leasing BV. The managers added a new position during the quarter in Cabot, a specialty chemicals company. Long positions in Surgutneftegas, Expedia, Oracle, WPP PLC, and Glencore bonds were eliminated.

Gross long exposure to equities is almost 70% and net exposure is approximately 65%. Credit holdings are close to 5%, while cash is approximately 30%. The largest sector concentration is in financials, with communication services (encompassing several internet names), information technology, and industrial sectors following. These four sectors comprise over half of the equity portfolio. With volatility returning to the market, the team continues to search for high quality, value opportunities for inclusion in the portfolio. They also still view high yields bonds as unattractive given historically low yields and spreads to treasuries.

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed Income strategy returned 2.4% during the first quarter. High yield corporate bonds contributed to return as spreads substantially narrowed during the quarter amid diminished volatility. Strong earnings and an optimistic economic outlook have allowed a decent carry environment to persist. Loomis increased high-conviction positions during the market weakness at the end of December, but has already started to reduce exposure back to levels consistent with a tighter spread environment. Increasing energy prices continued to provide a strong tailwind during the quarter, given the high energy weight within the high yield market. Individual energy and communications names helped performance the most.

The highly diversified group of bank loans contributed to positive performance, led by selected communications, capital goods, and consumer non-cyclical names. Securitized assets in all categories (ABS, non-Agency RMBS, and CMBS) produced positive returns during the period. ABS exposure, the largest of the three sectors, had positive results from many of the sub-sectors including subprime auto loans, aircraft related, and student loans. Non-Agency RMBS also added positive contribution as housing continued to do well despite showing signs of slowing. Sentiment remained positive as mortgage rates remain attractive for borrowers.

Global rates tools, primarily sovereign bonds, interest rate swaps (IRS), swaptions, and futures, detracted from performance, as the yield of the benchmark 10-year US Treasury dropped 28 bps to 2.41%. A short position in Euro Bund futures was the largest detractor from returns. South African and Argentine sovereigns positively contributed to partially offset the negative performance. Currency positioning also marginally weighed on performance mainly due to positions in the Hungarian Forint and Norwegian Krone. The US dollar strengthened during the quarter and currency markets remained focused on the pace of global growth. Election outcomes, trade policy, and increasingly tenuous Brexit terms between the EU and UK also remained important factors within currency markets. The Fed’s message of patience should be positive for these positions, but currency positions are still a relatively small part of the strategy’s risk exposure.

Water Island: The Arbitrage and Event-Driven strategy generated a return of 2.1%. Both sleeves of the portfolio contributed positively, with +160 bps from merger arbitrage (+129 bps from equity-based merger arbitrage and +31 bps from credit-based merger arbitrage) and +78 bps from special situations (+25 bps from equity special situations and +53 bps from credit special situations). (Sub-strategy attribution is based on gross attribution.)

The top contributor in the portfolio for Q1 2019 was a special situations investment in Xerox. In 2018, Water Island established a position in Xerox following a public dispute between the company and its largest shareholder after the company announced an ill-conceived merger with its longstanding partner Fuji Xerox (owned by FujiFilm Holdings). Xerox’s largest shareholder successfully sued the company for breaching its fiduciary duties in negotiating the Fuji Xerox transaction, preventing the transaction from proceeding, and ultimately leading to the replacement of its CEO and a majority of its board of directors. With new management and a new board in place, the company plans to maximize shareholder value through a turnaround process while seeking strategic alternatives for all or parts of the company. This position was a detractor in Q4 due to a technical dislocation amidst the broader market sell-off. Shares rallied this quarter following the establishment of better-than-expected 2019 earnings guidance as well as a highly successful inaugural analyst day the company hosted with its new management team.

The top detractor in the portfolio for Q1 2019 was a merger arbitrage investment in Newmont Mining’s acquisition of Goldcorp. In January 2019, Newmont Mining announced it had reached a definitive agreement to acquire Goldcorp for $10.0 billion. After the announcement of the deal, Barrick Gold Corp approached Newmont with an acquisition offer, which ultimately resulted in a joint venture rather than an acquisition. Newmont shareholders subsequently complained that the consideration paid to Goldcorp shareholders should be reduced due to the joint venture and threatened to vote against the deal if the structure weren’t changed. Rather than renegotiate terms, Newmont elected to distribute a larger portion of the joint venture proceeds as a one-time special dividend to existing shareholders, leading to a drop in Newmont’s share price and a widening of the spread in proportion to the amount of the special dividend. The team maintains a position in the deal and expects a successful completion in Q2 2019.

Water Island remains constructive on merger arbitrage. While the direction of interest rates in the near term has become unclear, current levels are supportive of a healthy spread environment. The pace of deal flow slowed in Q1, but Water Island believes this was a temporary blip due in part to the hangover from the turmoil of late 2018. The primary concern for the strategy remains the regulatory approval process, as deal timelines have increased somewhat. Additionally, after the DOJ’s attempt to block AT&T’s acquisition of Time Warner, the team has seen a shift in rhetoric from regulatory agencies not just in the US but globally, and anticipates very large vertical mergers being reviewed more closely on a more frequent basis.

Many of the issues that precipitated the market sell-off in Q4, from trade wars to rate hike fears, have since softened – or at least investor perception has. Thus, the Q1 rebound makes some sense, and with that in mind, the long-short balance in special situations investments (on an alpha security basis) is currently tilted toward the long side. Spin-offs should present significant opportunity for this sleeve of the portfolio, as the 2019 calendar of announced spins is robust. One area where Water Island is currently cautious is in speculative M&A, as the managers have noticed a drop in the accuracy of reporting around rumored deals from some reputable publications.

The portfolio’s emphasis on harder-catalyst positions remains intact despite the market rally. At quarter-end, approximately 76% of capital (from an alpha perspective) was allocated to merger arbitrage opportunities (including both equity- and credit-based). The remaining 24% was split evenly across equity and credit special situations.

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 divergence.

Sub-Advisor Portfolio Composition as of March 31, 2019
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy


Bond Portfolio Top 5 Sector Long Exposures as of 3/31/19
Consumer Discretionary 13.5%
High Tech 12.0%
Energy 11.5%
Investment Vehicles / REITs 9.6%
Consumer Non-Discretionary 9.1%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 86 75
Average Credit Duration (yrs.) 4.8 4.9
Spread 130 bps 147 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 3/31/19
Cash -5.5%
Government 0.0%
Agency Inverse Floaters 6.6%
Agency Inverse Interest-Only 5.9%
Agency CMO 10.4%
Agency PO 2.3%
Collateralized Loan Obligations 5.0%
Commercial MBS 6.7%
ABS 6.7%
Bank Loan 4.9%
High-Yield 0.0%
Municipals 2.9%
Non-Agency Residential MBS 54.1%
Total

100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 3/31/19
U.S. Stocks 47.9%
Foreign Stocks 21.0%
Bonds 4.6%
Other Asset-Backed 0.0%
Limited Partnerships 0.8%
Short Sales -3.8%
Cash 29.7%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 3/31/19

Long Total
Short Total
Net Exposure
Securitized 35.7% -0.8% 34.9%
Investment-Grade Corp. 23.0% -1.2% 21.8%
High-Yield Corporate 8.5% 0.0% 8.5%
Bank Loans 7.3% 0.0% 7.3%
Dividend Equity 7.0% -5.8% 1.2%
Emerging Market 3.2% -1.5% 1.7%
Convertibles 3.2% 0.0% 3.2%
Global Rates 2.7% -11.3% -8.6%
Currency 2.5% 0.0% 2.5%
Global Credit 1.2% 0.0% 1.2%
Risk Management 0.0% -4.3% -4.3%
Subtotal
94.3%
-24.9%
69.4%
 
Cash & Equivalents
8.4%
0.0%
8.4%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 3/31/19

Long Short Net
Merger Arbitrage – Equity 86.1% -24.3% 61.8%
Merger Arbitrage – Credit 11.4% -0.3% 11.1%
Total Merger-Related 97.5% -24.7% 72.9%
Special Situations – Equity 14.7% -12.3% 2.4%
Special Situations – Credit 15.2% -0.2% 15.0%
Total Special-Situations 29.9% -12.5% 17.4%
Total 127.4% -37.1% 90.3%