Litman Gregory Masters Alternative Strategies Fund Second Quarter 2019 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 1.83% in the second quarter of 2019. During the same period, the Morningstar Multialternative category was up 1.11%, and 3-month LIBOR returned 0.70%. Year-to-date through June 30, the fund is up 5.85% while the category and 3-month LIBOR are up 5.22% and 1.42%, 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 Alternative Strategies Fund had another solid quarter in Q2, gaining almost 1.9% and bringing year-to-date gains to almost 5.9%. We certainly won’t complain about that performance, but as we look at the zooming U.S. equity and credit indexes, we are left scratching our heads a bit. Despite the litany of risk factors present, the market continues to handsomely reward simply being long risk assets. Sure, from time to time, there may be a 10% (or more) drawdown, but if you just hold on tight, the Fed will swoop in to the rescue, China will stimulate, or something else will happen to reinforce the notion that risk is a temporary annoyance, best ignored until it inevitably goes away.

We’re pretty sure this can’t go on indefinitely, although we don’t know how long it will last or what will cause it to change. A massive regime change (or “paradigm shift,” as Bridgewater’s Ray Dalio called it in his thought-provoking recent essay) may be the ultimate end, after central banks eventually crush the premium for holding risky assets down to the levels of cash, and further stimulus has no effect on asset prices. Or it may not be… We aren’t clairvoyant or smart enough to know exactly what the future holds for markets.

However, given very rich valuations in U.S. equities and credit, and ultra-low/negative sovereign yields in much of the world, it feels to us like investors are walking a tightrope that keeps getting higher while the safety net keeps getting smaller. The Alternative Strategies Fund isn’t designed to explicitly hedge tail risk, nor will it bet the farm on any particular outcome, but it will invest prudently, increasing exposures at lower valuations/wider spreads, and vice versa. At the sub-advisor level, our managers look for ways to benefit from the environment, such as FPA adding capital structure arbitrage trades that can benefit from market dislocations, and are cheap to put on due to compressed credit spreads between senior and subordinated debt. These are small positions overall but serve as a useful illustration of the manager expertise and flexibility we think will benefit the fund in navigating an increasingly risky and uncertain environment. We also continue to evaluate other strategies that could potentially increase the fund’s resilience across a range of market outcomes.

 

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 6/30/19
 
MASFX
Bloomberg Barclays Agg Bond
Morningstar Multi-Alternatives Category
HFRX Global Hedge Fund
Russell 1000
Annualized Return
4.73 2.82 1.74 1.38 15.51
Total Cumulative Return
43.12 24.08 14.29 11.25 205.62
Annualized Std. Deviation
3.21 2.83 3.48 3.70 11.74
Sharpe Ratio (Annualized)
1.26 0.79 0.33 0.22 1.24
Beta (to Russell 1000)
0.24 -0.02 0.27 0.26 1.00
Correlation of MASFX to…
1.00 -0.12 0.80 0.72 0.78
Worst Drawdown
-6.94 -4.52 -8.21 -10.82 -17.42
Worst 12-Month Return
-4.49 -2.47 -6.08 -8.19 -7.21
% Positive 12-Month Periods
85.88% 76.47% 75.29% 67.06% 94.12%
Upside Capture (vs. Russell 1000)
28.42 8.25 21.72 20.43 100.00
Downside Capture (vs. Russell 1000)
23.82 -8.41 37.45 37.84 100.00
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 sub-advisors produced positive returns. FPA’s Contrarian Opportunity strategy was up 3.22%, DoubleLine’s Opportunistic Income strategy gained 2.85%, the DCI Long-Short Credit strategy increased by 2.12%, the Loomis Sayles Absolute Return strategy was up 0.95%, and Water Island’s Arbitrage and Event-Driven strategy returned 0.51%. (All returns are net of the management fee charged to the fund.)

Key performance drivers and positioning by strategy

DCI: DCI’s positive 2.1% return in Q2 was driven by consistent alpha in both the bond and CDS portfolios. Returns were boosted by positive interest rate returns, as the portfolio benefited equally in the quarter from positive yields and persistently falling risk-free rates. Returns from net credit market exposure were flat for the quarter, with hedging instrument slippage in June offsetting small positive beta returns (i.e., the derivatives used for hedging long risk outperformed cash bonds in June during the strong credit rally).

The strategy delivered positive returns each month in Q2 (as it has all year), benefiting from rising volatility and an increased market focus on credit fundamentals. Alpha was widespread in both the long and short CDS portfolios in Q2, with particularly strong performance in high-yield exposures. Asset selection in the bond portfolio was broadly positive across sectors, with most of the bond alpha appearing in June as the market recovered from its May swoon. Asset selection gains in Q2 were strong in long CDS positions in the media, insurance, and consumer sectors, and short positions in steel companies. Strategy performance in the energy sector was more mixed, as underperforming long exposures in Transocean and Chesapeake Energy offset more positive sector contributors during the quarter.

It is noteworthy that strategy alpha was consistently strong in both the downturn and the recovery phases during the quarter. As always, the portfolio’s construction remains 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. This construction worked particularly well in Q2. At quarter-end, the portfolio’s short exposures in raw materials and European banks, which were quite profitable in Q2, were substantially trimmed. Net CDS energy exposure shifted from long to slightly short, while the portfolio remains modestly long exposure to media and insurance firms. Net credit market beta is low and interest rate exposure is hedged to very short duration. 

DoubleLine: For the second quarter of 2019, the Opportunistic Income strategy generated a positive total return of almost 2.9%, but underperformed the Bloomberg Barclays US Aggregate Bond Index return of 3.08%. The relative underperformance was due to the portfolio’s shorter duration than that of the benchmark as 2-year and 10-year U.S. Treasury yields fell sharply during the quarter by 51 basis points (bps) and 40 bps, respectively.

Fund investments with coupons indexed to 1-month and 3-month LIBOR such as Collateralized Loan Obligations (CLOs) and bank loans experienced price declines in June as the Federal Reserve signaled the possibility of rate cuts in the near future. In addition, some structured credit products experienced spread widening as the U.S.-China trade conflict escalated throughout the quarter—especially during May and June—with no conflict resolution until the G20 summit in Japan on June 29, which occurred after the final trading session of the quarter. Asset-backed securities (ABS) and Agency mortgage-backed securities (MBS) outperformed the benchmark during the period while the remainder of the portfolio’s sector representation performed in line with or short of the benchmark’s return.

DoubleLine added a modest (4%) allocation to emerging-market dollar-denominated bonds during the quarter, bringing the credit book excluding non-Agency RMBS to around 30%. The strategy ended the quarter with a duration of approximately 4.7 and a yield to maturity of 4.7%.

FPA: The portfolio again delivered solid gains (up over 3%), although not as dramatic as the first quarter’s +10% rebound. Top contributors for Q2 were Arconic, AIG, TE Connectivity, Citigroup, and Facebook, while the largest detractors were Baidu, Mylan, Alphabet, Glencore, and Altaba.

New positions in the second quarter included Olympus on the long side and a short in AT&T. The portfolio managers eliminated small remaining long positions in Axalta and Alcoa. The portfolio managers have also begun adding some capital structure arbitrage trades, where they are able to go long senior parts of the capital structure (loans) and short more junior parts (bonds) at very narrow spreads. The net positioning has very little cost and should benefit asymmetrically in the event of weakness in the credit markets generally, or if company-specific issues develop. Two of these pair trades were established during the quarter (accounting for a very small gross allocation), and the portfolio managers expect to add more if market conditions remain favorable for the strategy.

The portfolio remains interestingly “barbelled,” with the largest sector concentration in financials at almost a quarter of the portfolio, and another value-oriented sector (industrials) also accounting for significant exposure. Meanwhile, the “growth-ier” and generally higher quality communication services and information technology sectors together are almost equal to the weighting of financials. These sectors include names like Alphabet, Facebook, Baidu, and Tencent (via Naspers), which may not look cheap on simple valuation metrics, but where the investment team believes the combination of growth, “hidden” assets, and competitive positioning create attractive long-term franchise values.

Gross long exposure to equities is 68.7% and net exposure is approximately 62.9%. Credit holdings are 4.6% of assets. Cash is approximately 31.8%.

Loomis Sayles: The Absolute Return strategy gained almost a percent during the quarter. Securitized assets across all major sectors contributed to returns during the period. ABS, non-Agency RMBS, and CMBS issues all generated positive performance. ABS exposure had positive results from many sub-sectors, including subprime auto loans, aircraft related, and credit card debt. Non-Agency RMBS gained as housing generally continued to do well with rates remaining attractive for borrowers, supporting positive sentiment. Investment-grade (IG) corporate bonds, including the ones held for reserves, bolstered performance despite marginal IG spread widening during the quarter. A continuation of accommodative Fed policy provided a major tailwind during the period. Financials, technology, and consumer non-cyclical names were responsible for most of the positive contribution.

The strategy’s allocation to high-yield credit weighed on performance during the quarter, despite a generally solid quarter for risk assets and marginally tightening high-yield spreads. Much of the negative quarterly performance can be attributed to the May U.S./China trade war escalation and weak energy prices. Within the portfolio, energy and consumer non-cyclical names detracted. Equities also negatively impacted performance, again driven by weaker energy prices that resulted in declines in energy-related stocks. (Net equity exposure is very small, at less than 2%, but the energy-heavy long book has not kept up with the index-focused hedges.)

Strategy exposure continues to be dominated by securitized assets, at almost one-third of the portfolio, with IG corporate bonds (slightly over 20%) and high-yield (just over 10%) the other most significant exposures. Despite fairly conservative positioning, the portfolio’s yield is close to 5%, with a duration of less than 2 years.

Water Island: The merger arbitrage sleeve of Water Island’s portfolio was the primary driver of returns in the quarter, contributing 99 basis points, with 89 bps from equity-based merger arbitrage and 10 bps from credit-based merger arbitrage. The special situations book was essentially flat, as credit special situations contributed 38 bps while equity special situations detracted 39 bps (all returns gross of fees).

The top contributor in the portfolio for Q2 was a competitive bidding situation for Anadarko Petroleum. In April 2019, Chevron publicly announced it had agreed to acquire Anadarko for $32.5 billion in cash and stock. Prior to the announcement of the deal, Anadarko had also been conducting negotiations with another bidder—Occidental Petroleum—though the company deemed Chevron’s bid to be the more attractive offer. Two weeks after the deal with Chevron was announced, Occidental publicly announced an unsolicited revised offer that valued Anadarko at $38.0 billion in cash and stock, topping Chevron’s bid. Anadarko ultimately declared Occidental to have the superior offer, at which point Chevron abandoned its pursuit of the company. The acquisition is currently pending and anticipated to close by the end of 2019.

Conversely, the top detractor for the quarter was Illumina’s proposed acquisition of Pacific Biosciences. In November 2018, Illumina—a U.S. developer of genetic analysis tools—agreed to acquire Pacific Biosciences—a U.S. DNA sequencing technology firm—for $1.1 billion in cash. The spread widened in Q2 following reports that UK regulators had opened an investigation into the deal, thus extending the timeline. The portfolio managers maintain exposure to the deal, believing it will ultimately reach a successful conclusion.

Water Island remains highly constructive on merger arbitrage. Deal spreads are buoyed by short-term interest rates, and while the future direction of rates is now much less certain than a year ago, the firm believes current levels still support a healthy spread environment. Deal volume is strong, with the total value of announced deals for the first half of 2019 being the second greatest for a first-half period since the Financial Crisis (behind only 2018). Furthermore, additional M&A activity is likely to be spurred by private equity buyers, who by some estimates have nearly $2.5 trillion in dry powder waiting to be deployed. Lastly, the ongoing presence of volatility in the markets can present opportunities to take advantage of favorable entry points in many M&A transactions. As such, the three primary drivers of merger arbitrage returns—interest rates, deal flow, and volatility—are positioned to create a profitable environment for the strategy.

 

The firm’s optimism, however, is tempered by caution. The primary concern continues to be the regulatory approval process, the timelines of which have begun to extend relative to historical norms. In the United States, the Federal Trade Commission (FTC) seems more willing to take on transactions that previously would have been approved without objection. In the UK—in preparation for a world in which the country is no longer a European Union (EU) member—regulators have also stepped up their own reviews of M&A transactions. Additionally, amidst the ongoing trade war between the United States and China, there is continuing potential for any given deal to be used as a pawn in the negotiating process. In this atmosphere of unpredictability, properly sizing positions relative to downside risk becomes increasingly important and Water Island is continuously attempting to balance return generation with additional protection through hedges.

The special situations team continues to see opportunity in speculative M&A, asset sales, re-ratings, and spin-offs. The number of announced spin-offs for 2019 is already above average, with the total value of announced spins for the first six months of the year having reached a record for the post-Financial-Crisis period. While equity market valuations have rebounded since the lows of Q4 2018, the team continues to see the market undervalue spin-offs and other re-rating opportunities relative to history. Despite the positive view on the softer catalyst opportunity set, the portfolio managers continue to maintain a focus on more definitive events in the portfolio. With credit and equity markets still trading at all-time highs more than a decade after the nadir of the Great Recession, Water Island is wary of the increased risk inherent in softer catalyst situations, despite the potential for higher returns. The investment team views merger arbitrage spreads as attractive at current levels, and at quarter-end approximately 85% of capital (from an alpha perspective) was in merger-related opportunities.

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 June 30, 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 6/30/19
Consumer Discretionary 17.2%
Energy 13.1%
High Tech 11.4%
Consumer Non-Discretionary 10.1%
Media 6.6%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 90 78
Average Credit Duration (yrs.) 4.6 4.7
Spread 103 bps 110 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 6/30/19
Cash -8.1%
Agency Inverse Floaters 6.8%
Agency Inverse Interest-Only 5.6%
Agency CMO 10.6%
Agency PO 2.5%
Collateralized Loan Obligations 4.9%
Commercial MBS 8.6%
ABS 7.2%
Bank Loan 5.2%
Emerging Markets 4.0%
Municipals 1.0%
Non-Agency Residential MBS 51.7%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 6/30/19
U.S. Stocks 48.3%
Foreign Stocks 20.4%
Bonds 4.6%
Other Asset-Backed 0.8%
Short Sales -5.8%
Cash 31.8%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 6/30/19

Long Total
Short Total
Net Exposure
Securitized 32.3% -0.8% 31.5%
Investment-Grade Corp. 22.1% -1.2% 20.9%
High-Yield Corporate 10.3% 0.0% 10.3%
Dividend Equity 7.0% -5.1% 1.9%
Bank Loans 6.6% 0.0% 6.6%
Global Rates 3.1% -4.2% -1.2%
Emerging Market 2.5% 0.0% 2.5%
Currency 2.4% -2.0% 0.3%
Convertibles 2.3% 0.0% 2.3%
Global Credit 1.1% 0.0% 1.1%
Risk Management 0.0% 0.0% 0.0%
Subtotal
89.6%
-13.4%
76.3%
 
Cash & Equivalents
12.9%
0.0%
12.9%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 6/30/19

Long Short Net
Merger Arbitrage – Equity 96.3% -42.0% 54.3%
Merger Arbitrage – Credit 7.9% -0.4% 7.5%
Total Merger-Related 104.2% -42.4% 61.8%
Special Situations – Equity 7.8% -4.8% 3.0%
Special Situations – Credit 9.7% -0.4% 9.3%
Total Special-Situations 17.5% -5.2% 12.3%
Total 121.6% -47.6% 74.1%