Litman Gregory Masters Alternative Strategies Fund Third Quarter 2019 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 0.60% in the third quarter of 2019. During the same period, the Morningstar Multialternative category was up 0.54%, and 3-month LIBOR returned 0.63%. Year to date through September 30, the fund is up 6.48% while the category and 3-month LIBOR are up 5.74% and 2.06%, 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 gained 60 basis points (bps) in the third quarter, bringing year-to-date returns to 6.48%. The quarter was relatively quiet in terms of performance, consistent with the fairly muted returns of developed-market stock indexes and credit markets. We are pleased to have produced a good absolute return this year, especially given what we would still consider overall conservative positioning. It has been gratifying to see DCI rebound strongly this year following a challenging 2018, and they were the top performer in the third quarter, benefiting from strong credit selection. DoubleLine was also a significant contributor, as the portfolio benefited from having some duration (almost five years at the beginning of the quarter) as rates continued to fall.

However, the fund has trailed the returns of long-only, passive exposure to U.S. stocks, as well as both investment-grade (IG) and high-yield (HY) bonds. As we have mentioned before, the continued, simultaneous very strong returns of “safe” assets like IG bonds and “risky” assets like stocks and HY cannot continue indefinitely. There is only so much spread left between the two categories for loose (or even unconventional) monetary policy to squeeze out. At some point, we assume investors will want more compensation for taking equity and credit risk (not to mention the interest rate risk that had worried investors only a few quarters ago).

In some sense, it feels like markets are in a holding pattern, with brief directional moves up or down depending on news flow, but ultimately waiting for clarity to emerge on international relations and trade wars, central bank policy, fiscal stimulus from China and Europe, and global economic growth (or decline). We continue to believe prudence favors waiting for better opportunities before deploying capital aggressively. Still, our sub-advisors have generally been able to take advantage when there have been pockets of volatility, while the less-directional strategies have managed to grind out decent returns. There are several managers in the fund whose positioning seems likely to enjoy a modest bump if economic growth surprises to the upside, but overall, the fund is conservatively positioned and should be in position to increase exposures when (if?) financial markets ever again take a sustained break from their upward trajectory.

 

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 9/30/19
 
MASFX
Bloomberg Barclays Agg Bond
Morningstar Multi-Alternatives Category
HFRX Global Hedge Fund
Russell 1000
Annualized Return
4.66 3.02 1.75 1.54 15.19
Total Cumulative Return
43.99 26.90 14.91 13.04 209.96
Annualized Std. Deviation
3.17 2.92 3.43 3.65 11.61
Sharpe Ratio (Annualized)
1.24 0.82 0.33 0.26 1.22
Beta (to Russell 1000)
0.23 -0.03 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
86.36% 77.27% 76.14% 65.91% 94.32%
Upside Capture (vs. Russell 1000)
28.34 7.94 21.73 20.71 100.00
Downside Capture (vs. Russell 1000)
23.46 -11.65 36.80 36.40 100.00
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, three of the five sub-advisors produced positive returns. DCI’s Long-Short Credit strategy increased by 2.41%, DoubleLine’s Opportunistic Income strategy gained 1.94%, and the Water Island Arbitrage and Event-Driven strategy returned 0.81%. On the negative side, FPA’s Contrarian Opportunity strategy declined 0.36% and the Loomis Sayles Absolute Return strategy lost 1.06%. (All returns are net of the management fee charged to the fund.)

Key performance drivers and positioning by strategy

DCI: Alpha was broadly positive across the portfolio, with both the credit default swap (CDS) sleeve and bond sleeve making strong contributions. Net beta effects were about flat as the hedging performed roughly as expected and the moves in the underlying credit (negative) and rates (positive) were about offsetting. 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 constructed to be about neutral to credit beta, which was demonstrated by the strategy’s performance across the divergent environments this year.

Market sentiment gyrated in the quarter as renewed central bank easing bolstered asset values against the headwinds of slowing global manufacturing and rising geopolitical risk factors. Equities ended about flat, with oil down 8%, while bonds and perceived safe assets soared. Credit returns behaved in line and ended the quarter a bit negative. Treasury yields were lower by 20 to 30 bps across the curve as investors priced in new rate cuts and a more accommodative policy path.

Security-selection alpha in the DCI portfolio was broadly positive for the quarter, even with a bit of a pullback in September. Long positions in media, consumer, rentals, and technology contributed to the gains, while shorts in retail and industrials led the losses. Energy was mixed. Some troubled firms with weak fundamentals that had contributed to portfolio gains over the summer benefited from the market’s temporary swing in sentiment and contributed to losses in September.

Positioning was mostly steady over the quarter, although it moved more neutral in energy, consumer goods, and materials. The model still sees attractive short positions in energy and retailers, with longs in media, finance companies, and insurance. As always, the credit selection portfolio favors improving fundamentals and strong credit quality.

DoubleLine: For the third quarter of 2019, the DoubleLine Opportunistic Income strategy’s 1.9% return slightly underperformed the Bloomberg Barclays U.S. Aggregate Bond Index return of 2.3%. The relative underperformance was primarily due to duration positioning as 2-year and 10-year U.S. Treasury yields continued their year-to-date declines, falling 13 bps and 34 bps over the quarter, respectively. This hindered relative performance as the portfolio is consistently managed with a duration shorter than that of the index.

Nevertheless, almost every sector within the portfolio generated a positive return, with agency mortgage-backed securities (MBS) and asset-backed securities (ABS) leading the way. The agency MBS allocation outperformed the index due to the inclusion of Inverse-Interest Only and Inverse-Floater structures. These are some of the longest-duration securities within the portfolio and thus perform the best when rates fall. The outperformance in the ABS allocation was driven by price appreciation in esoteric sectors such as Aircraft ABS and Whole Business ABS. Strong investor sentiment coupled with solid underlying credit performance propelled these sectors higher during the quarter.

In terms of performance laggards, emerging-market corporate bonds and collateralized loan obligations (CLOs) were the worst-performing sectors within the portfolio. The emerging-market debt complex was negatively impacted by the sharp move higher in the U.S. dollar over the quarter, while the CLO market continues to be plagued by a falling LIBOR index that results in lower floating-rate coupon payments to investors. The strategy ended the quarter with a duration of approximately 4.0 and a yield to maturity of 4.8%.

FPA: The portfolio declined slightly, losing less than half a percent, as some Internet names were hurt (though Alphabet did well), along with PG&E’s continued struggles. Top contributors in the third quarter were Alphabet, Meggitt, American International Group, Puerto Rico municipal bonds, and the long Comcast/short AT&T pair trade. The largest detractors were Owens-Illinois, the long PG&E/short Utilities ETF pair trade, the long CIT/short Regional Banks ETF pair trade, Baidu, and Facebook.

New positions throughout the quarter included a Dell long-term loan/short bond pair trade, a McDermott International revolver and term loan, and a Barneys New York term loan. The fund also received shares in Prosus (Naspers’ international Internet businesses) as a result of a spinoff by Naspers. There were no position size increases or decreases greater than 25% during the quarter.

Gross long exposure to equities is 66.9% and net exposure is approximately 56.9%. Credit holdings are 5.4% of assets, while cash increased by over five percentage points to approximately 36.7%.

Loomis Sayles: The Absolute Return strategy lost slightly more than one percent during the quarter. IG corporate bonds, including the ones the portfolio holds for reserves, were strong performers over the quarter. A continuation of accommodative Fed policy provided a major tailwind during the period. Financials, consumer non-cyclicals, and capital goods names were responsible for most of the positive contribution. Securitized assets across all major sectors also contributed to returns during the period. ABS, non-agency RMBS, and commercial MBS contributed the most (in that order). ABS exposure had positive results from many of the sub-sectors, including subprime auto loans, aircraft-related, and credit card debt.

HY credit weighed on performance during the quarter despite a generally constructive quarter for risk assets, with HY spreads marginally tightening. Much of the negative quarterly performance can be attributed to weak energy prices and the escalation of U.S.-China trade tensions in August, as energy and consumer non-cyclical names in the portfolio detracted the most. Equities also lost ground, with weaker energy prices again a source of pain, given the portfolio’s weighting in energy-related names.

The portfolio remains quite conservatively positioned. IG corporate bonds and securitized assets continue to be the largest exposures, at almost one-third of the portfolio each, although much of the IG corporate exposure is very short-duration, with the goal to have a ready source of liquidity for future opportunities, while earning somewhat more than the yield on cash. No other sector exposure (excluding cash at 11%) is above 10%. HY (almost 6% net) is the next-largest exposure. Despite fairly conservative positioning, the portfolio’s yield is still approximately 5%, with a duration of less than 2 years.

Water Island: The merger-arbitrage sleeve of the portfolio was the primary driver of returns, contributing over 1% gross (almost entirely from equity-based merger-arbitrage positions). Special situations was very slightly negative on balance, with equity special situations detracting a tiny amount more than credit special situations contributed.

The top contributor in the portfolio for the third quarter was again Anadarko Petroleum. In May 2019, following a brief bidding war with Chevron, Occidental—a U.S.-based upstream energy company—reached a definitive agreement to acquire Anadarko, a local peer, for $38 billion. In the second quarter, an activist investor attempted to push Occidental to sell itself rather than follow through with the Anadarko acquisition, believing it would unlock greater value. This sent the deal spread wider into the third quarter. Nonetheless, the company elected to proceed with the transaction, shareholders voted to approve the merger, and the deal successfully closed in the third quarter, leading to gains for the fund.

The largest detractor for the quarter was also the same as the previous quarter: Illumina’s proposed acquisition of Pacific Biosciences. In November 2018, Illumina—a U.S. developer of tools for analysis of genetic variation and function—agreed to acquire Pacific Biosciences—a U.S. DNA sequencing technology firm—for $1.1 billion in cash. This deal spread initially widened in the second quarter when the United Kingdom’s Competition Market Authority (CMA) initiated a regulatory review, thus extending the timeline for completion later in 2019. The spread further widened during the third quarter as the CMA forwarded the transaction to Phase II, pushing the timeline out to 2020. Water Island has maintained its exposure, as the team believes the CMA’s interpretation of overlap in the companies’ businesses is overly broad and that the CMA would have a weak case if it attempted to block the deal.

During the third quarter, the Fed cut interest rates by 25 bps on two separate occasions. Nonetheless, average deal spreads remained largely unchanged over the quarter. However, there is a wide disparity between rates of return in the safest, most solid deals (low single digits) and in the riskier transactions (double digits). Private equity remains a strong source of acquisition activity—in some instances even competing with strategic buyers who could realize more significant synergies (and thus afford to pay a higher price). Increasing shareholder activism has also spurred consolidation activity. That said, while deal flow for the first half of the year reached near-record levels, the pace of announcements slowed dramatically in the third quarter. Water Island believes that increasing uncertainty around resolutions to both Brexit and the U.S.-China trade war has many corporate boards pausing planned mergers & acquisitions (M&A) activity. Regulatory risk continues to be a primary concern. In the United States, the Committee on Foreign Investment in the United States (CFIUS) appears poised to once again expand the scope of deals it may review for national security concerns and the U.S.-China trade war continues to put at risk deals which are subject to review by CFIUS and China's State of Administration for Market Regulation. Lastly, the CMA continues to expand its purview as it prepares for a world in which the United Kingdom performs its own competition reviews outside the European Commission, causing further delays in deal timelines.

The Water Island investment team continues to see signs that market participants believe valuations are close to peak levels and that a recession is increasingly near. One indication is an uptick in the number of deals including contingent value rights as part of the payment—perhaps because buyers believe valuations are at their peak and are only willing to pay top dollar for successful outcomes. There has also been evidence of potential buyers with weaker credit encountering more difficulty completing financing for acquisitions (which isn't necessarily a bad thing, as it can require buyers to be more prudent with deal terms). In addition, there has been an increase in the number of announced spinoffs and asset sales that appear to be predicated on companies seeking to bifurcate what they see as more cyclical businesses from more resilient core businesses in advance of the next recession.

Water Island has observed more speculative reporting in the press about potential M&A, but these speculative situations have become riskier potential investments, as the percentage of deals using acquirer stock as payment has increased. This is typical of late-cycle periods, when shares are richly valued, and leaves the potential upside on a speculative investment highly dependent on an uncertain reaction in an acquirer’s future share price. Given the abundant risks in the world and high valuations, the Water Island portfolio managers continue to concentrate the portfolio in more definitive events (approximately 86% of capital at quarter-end was in merger-arbitrage positions) in an effort to derive returns from deal-specific outcomes rather than market beta.

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, 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 9/30/19
Consumer Discretionary 18.5%
Energy 16.2%
High Tech 9.2%
Consumer Non-Discretionary 8.7%
Media 8.6%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 78 75
Average Credit Duration (yrs.) 4.9 4.9
Spread 127 bps 137 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 9/30/19
Cash -7.7%
Agency Inverse Floaters 7.2%
Agency Inverse Interest-Only 5.8%
Agency CMO 9.3%
Agency PO 2.7%
Collateralized Loan Obligations 5.6%
Commercial MBS 10.0%
ABS 6.3%
Bank Loan 5.2%
Emerging Markets 4.3%
Non-Agency Residential MBS 51.2%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 9/30/19
U.S. Stocks 46.9%
Foreign Stocks 20.0%
Bonds and Loans 5.4%
Limited Partnerships 1.1%
Short Sales -10.0%
Cash 36.7%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 9/30/19

Long Total
Short Total
Net Exposure
Investment-Grade Corp. 33.0% -1.2% 31.9%
Securitized 32.1% -0.7% 31.4%
High-Yield Corporate 7.8% -2.1% 5.6%
Dividend Equity 4.0% -3.2% 0.8%
Bank Loans 3.9% 0.0% 3.9%
Emerging Market 3.4% -1.9% 1.5%
Currency 3.3% -3.1% 0.3%
Convertibles 2.2% 0.0% 2.2%
Global Rates 1.6% -4.3% -2.7%
Global Credit 0.8% 0.0% 0.8%
Risk Management 0.0% 0.0% 0.0%
Subtotal
92.1%
-16.4%
75.7%
 
Cash & Equivalents
11.2%
0.0%
11.2%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 9/30/19

Long Short Net
Merger Arbitrage – Equity 80.7% -18.2% 62.5%
Merger Arbitrage – Credit 3.0% -0.3% 2.7%
Total Merger-Related 83.7% -18.6% 65.2%
Special Situations – Equity 6.2% -5.7% 0.5%
Special Situations – Credit 7.5% -0.2% 7.3%
Total Special-Situations 13.7% -5.9% 7.8%
Total 97.4% -24.4% 73.0%