Litman Gregory Masters Alternative Strategies Fund Fourth Quarter 2018 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) fell by 2.81% for the quarter ending December 31, 2018. During the same period, the Morningstar Multialternative Category declined 4.60% and 3-month LIBOR produced a gain of 0.58%. For the full year, the fund declined by 2.08%, while the category lost 4.77% and LIBOR gained 2.08%.

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.

Litman Gregory Masters Alternative Strategies Fund [MASFX – Institutional Class]
v. Barclays Aggregate, HFRX Global Hedge Fund Index and Morningstar Multi-Alternative Category

Litman Gregory Masters Alternative Strategies Fund [MASFX – Institutional Class] v. Barclays Aggregate, HFRX Global Hedge Fund Index and Morningstar Multi-Alternative Category

Quarterly Review

We discussed the fund’s recent performance in the last quarterly update after receiving a number of questions, but perhaps we should have waited … (We actually wrote a longer Q&A recently addressing some of the questions; available at www.mastersfunds.com) The fourth quarter was a rough one for investors. The fund wasn’t immune to the challenging environment, although relative to the declines in equity markets, high-yield bonds, and many alternative strategies, it performed reasonably well. Not well enough to post a positive return, but in line with our expectations of how it should hold up in a sharp correction. The resulting 2.1% loss for the year marks the second time the fund has shown a loss in a calendar year. The first time was in 2015 when event-driven and credit managers faced powerful headwinds in the form of large deal failures and widening credit spreads, exacerbated by selling pressure from hedge funds. That resulted in a loss of less than 1% on the year, and the fund rebounded with a strong return of almost 7% in the following year.

Last year frustrated investors almost across the board. Red ink spilled across almost every asset class and geography. High-yield spreads did widen significantly, getting back above 500 basis points (bps), levels last seen in 2016, although they haven’t come close to the peaks of almost 900 bps from early that year. Thus, we don’t have the same level of yield in the portfolio we did three years ago to help drive returns in the short term (and our managers don’t have very significant high-yield exposure), but we have seen varying levels of dislocation across a number of areas in capital markets that our managers have used to get somewhat more aggressively positioned, while still maintaining appropriate caution. We can never predict returns, but we have written previously about periods of “planting” versus “harvesting,” and we can say that the fourth quarter was certainly a period of planting for the fund’s sub-advisors. There is no guarantee that harvest season will be here imminently or without setbacks (we would guess there will be more opportunities to plant), but we feel confident that the fund will benefit from having had the ability to invest more during a rough period, despite admittedly uncomfortable performance along the way.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 12/31/18
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
4.25 2.18 13.91 1.15
Total Cumulative Return
35.22 16.94 157.16 8.62
Annualized Std. Deviation
3.12 2.75 11.22 3.32
Sharpe Ratio (Annualized)
1.18 0.62 1.18 0.21
Beta (to Russell 1000)
0.24 -0.02 1.00 0.27
Correlation of MASFX to…
1.00 -0.03 0.84 0.86
Worst Drawdown
-6.94 -4.52 -17.42 -8.21
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.08
% Positive 12-Month Periods
0.86 0.75 0.95 0.77
Upside Capture (vs. Russell 1000)
28.51 6.92 100.00 20.71
Downside Capture (vs. Russell 1000)
24.58 -6.56 100.00 38.39
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 fourth quarter, one manager produced positive performance and four produced negative returns. DoubleLine’s Opportunistic Income strategy gained 1.17%. Water Island’s Arbitrage and Event Driven strategy was down 0.49%, the Loomis Sayles’s Absolute-Return Fixed-Income strategy fell by 1.75%, DCI’s Long-Short Credit strategy was down 2.75%, and the FPA’s Contrarian Opportunity strategy lost 10.65%. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DCI: The DCI Long-Short Credit strategy was down by almost 2.8% in the fourth quarter, in a disappointing reversal of the positive third quarter performance. After struggling with a very unfavorable environment for the strategy for most of 2018 (low credit spreads, low volatility in credit markets, and the dramatic outperformance of low-quality credits over higher-quality credits), performance had begun to turn around in the third quarter before stumbling again in the fourth quarter.

Strategy performance was negative across the board in the fourth quarter, driven by negative security-selection returns in both the credit default swap (CDS) and bond portfolios. Residual exposure to beta was also a negative, with credit-beta losses on the falling market outpacing the positive gains from rates on a dovish re-pricing of the Federal Reserve. Credit hedging generated positive, but disappointing, returns amidst the declining market, as the benefits were limited by a differential between the short CDX derivative index (CDX North American High Yield Index) and the long exposure in the cash bonds, which widened at the end of the year. Even amidst the negative returns to the underlying proprietary DCI security selection, the team remains confident that higher spreads and an increased scrutiny on credit-worthiness should be positive tailwinds for the strategy going forward.

In a quarter with very negative high-yield credit returns, the CDX derivative index, which is used for hedging in this strategy, rebounded both at the end of November and again at the end of December as markets began to recover and, hence, closed the quarter notably better than the index of cash bonds (BofA Merrill Lynch US High-Yield Cash Pay Index). This differential was unusually large and arises from time to time, usually reflecting the greater pricing speed and investor responsiveness in the CDX—in this case an unwinding of hedges combined with sluggish cash-bond pricing. This suggests that the relative-performance differential of the two indexes should tend to converge in the first quarter and undo some of this gap, as generally the hedge has been extremely well-behaved. Rates made a positive contribution over the quarter as investor fears helped push down front-end rate expectations.

The increased spread levels and dispersion across credits brought by the selloff expands the opportunity set for the strategy. However, while security selection generally showed more traction in the second half of 2018, the difficult environment for alpha continued. Part of the challenge for security selection has been the disparate market crosscurrents and the persistent resiliency of lower-quality credits versus those with strengthening fundamentals.

In the fourth quarter, the long side of the portfolios tended to underperform with no overwhelming culprit (although the selloff in oil was a clear headwind for the strategy's energy exposure). Results were quite mixed, with the negative credit selection relatively spread out across names and sectors. Positions within the media, energy, pharma, consumer, and hospitals sectors were the largest detractors, partially balanced by relative gains from within the materials, tech, transport, and banking sectors. The biggest gainers were shorts in AK Steel and U.S. Steel, and in Thomas Cook Group. The largest detractors were longs in energy names Transocean and Weatherford International, and in pharma positions Endo International and Mallinckrodt. Periods of sustained heightened volatility and dispersion in credit markets have historically been positive for the strategy, and DCI remains of the view that the market will eventually reward credits with solid and improving fundamentals, as selected by the model.

In terms of positioning, the bottom-up credit selection models added marginally to attractive short positions in banks, energy, and materials, while increasing longs in utilities and consumer durables. Homebuilders have recently become more attractive after their credits were beaten up in a prolonged selloff throughout the year. Net sector exposures remain quite contained and are monitored on an ongoing basis, with the bulk of portfolio risk in single-name credit selection as intended by design.

DoubleLine: For the fourth quarter of 2018, the DoubleLine Opportunistic Income portfolio gained 1.2%. The positive performance was primarily due to sector allocation and security selection. The portfolio has no exposure to investment-grade corporates, which were the worst-performing sector within the index. The U.S. Treasury curve rallied as 2-year and 10-year yields were down 33 bps and 38 bps, respectively. Agency residential mortgage-backed securities (RMBS) were the largest contributors to performance due to the rate move. With the flight to safety seen across financial markets, credit spreads widened, resulting in price declines for most sectors. As a result, interest income was the primary performance driver, with positive carry more than offsetting downward price moves and resulting in non-agency RMBS, commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) exhibiting positive returns. Collateralized loan obligations (CLOs), bank loans, and Puerto Rico municipal bonds detracted from performance as prices declined. The portfolio’s duration increased a bit, with interest rates higher, to almost 5.1 years. Cash declined significantly from approximately 15% to under 3% of the portfolio. Although there were purchases elsewhere, the most meaningful additions were in credit sectors outside of non-agency RMBS (e.g., bank loans, CMBS, CLOs), which now make up over 25% of the portfolio. Non-agency RMBS is still the largest allocation, at almost 53%.

FPA: FPA’s Contrarian Opportunity strategy suffered a loss of over 10% during the quarter, with performance dragged down by exposure to financials, Internet names (that now fall into the new communication services sector), and industrials. The largest detractors were American International Group (which was particularly hard hit by natural disaster–related losses), Baidu, Arconic, Citigroup, and United Technologies. The top contributors for the quarter were Esterline Technologies, Broadcom, a short position in the iShares Russell 2000 ETF, Nexon, and Renault.

The volatility allowed for a significant repositioning of the portfolio. Cash declined by over five percentage points, and net exposure increased to approximately 71%. New positions that were established during the quarter included longs in Glencore, Signature Bank, General Electric perpetual preferred bonds, and Puerto Rico Sales Tax Revenue municipal bonds. The team also took advantage of the price volatility to increase positions in a number of financials like Ally Financial, American International Group, Royal Bank of Scotland, and Wells Fargo, as well as Mohawk Industries, and Asian tech positions Naver and Nexon.

The managers exited long positions in Bombardier bonds (above par), American Express, Esterline Technologies, Facebook, Mondelez International, and Thermo Fisher Scientific, while covering shorts in Alibaba Group Holding, Line, the iShares Russell 2000 ETF, and the iShares JPM USD Emerging Markets Bond ETF. Additionally, the Navistar bonds and the remaining commercial real estate loans matured. Positions in Aon, Expedia Group, and Oracle were trimmed, as was the short position in the Utilities Select Sector SPDR ETF (part of a pair trade with PG&E), and the Naspers/Tencent pair trade).

The portfolio’s largest sector concentration remains in financials, with communication services, industrials, and information technology sectors following. These four sectors make up over half of the equity portfolio. FPA continues to view high-yield bonds as largely unattractive, given still-low yields and spreads to Treasuries. However, they anticipate significant opportunities there in the coming quarters/years due to the massive growth in that market in recent years, as well as the huge increase in BBB-rated bonds in the investment-grade universe that could be downgraded and subject to forced selling.

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed-Income strategy was down approximately 1.8% during the quarter. Securitized assets, particularly ABS and non-agency RMBS, contributed the most to 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 contributed as housing generally continued to do well even as it showed some signs of slowing. Global credit contributed to performance as well, with Argentine issues having the largest positive impact. Despite recession conditions persisting for much of the quarter, some statistics suggest that the IMF’s credit extension and deepening austerity measures transitioned the country’s economy to the latter stages of recession. The resulting market optimism surrounding prospects for a near-term recovery led to gains in the quarter.

High-yield corporate bonds weighed on returns as spreads substantially widened during the quarter amid the return of higher volatility. Strong earnings and an optimistic economic outlook have allowed a decent carry (yield) environment to persist, but outflows from high-yield funds during much of the quarter demonstrated investor uneasiness. The decline in energy prices was a strong headwind during the quarter, given energy’s significant weighting in the high-yield market. Energy was the largest detractor, followed by communications and technology names.

Equities had a negative impact on performance as stock market volatility returned following spikes earlier in the year. Much of the negative impact can be attributed to positions in utilities and energy, due to lower oil prices.

Capital goods and financial names also hurt performance. The risk-off environment for equities continued throughout the period, as markets remained focused on the effects of the U.S. elections, U.S.-China trade conditions, and Fed policy. The team remains constructive on existing holdings, while looking to limit downside through hedges.

The portfolio’s highly diversified group of bank loans also detracted from performance. During the quarter, selected communications, capital goods, and technology names were the main detractors. The floating-rate nature of bank loans has been attractive relative to other sectors, and investors have also been drawn to the relative safety of loans, given their senior position in the capital structure. Although the team had been limiting exposure to high-yield through most of 2018 (adding as high-yield sold off in the fourth quarter, however), the bank loan allocation remained in double digits over the course of the year.

Water Island: In the fourth quarter, Water Island’s Arbitrage and Event-Driven strategy was down roughly half a percent after fees. While the merger-arbitrage sleeve of the portfolio contributed a total of almost 1.7% (gross) to returns (positive 157 bps from equity merger arbitrage and positive 10 bps from credit-based opportunities), softer-catalyst special situations detracted about 2% (negative 155 bps from equity special situations and negative 46 bps from credit).

The top contributor in the portfolio for the fourth quarter of 2018 was the equity merger arbitrage investment in the acquisition of Twenty-First Century Fox by Walt Disney. In December 2017, Disney entered into a definitive agreement to acquire the entertainment business of Fox for $52 billion. Following a brief bidding war with Comcast, which had launched its own bid for Fox in June 2018, Disney ultimately emerged with the superior offer, now valuing Fox at $71 billion. In November, the deal received regulatory approval from both the European Commission and from China, two key hurdles for completion. The deal spread tightened on the news, leading to gains for the portfolio. Brazil is now the sole outstanding regulatory approval and Water Island expects the transaction to be completed in the first quarter of 2019.

The top detractor in the portfolio for the fourth quarter of 2018 was a special situations investment in Herc Holdings. Herc is an equipment rental company serving primarily the commercial and residential construction sectors. The managers have been long Herc since its spinoff from Hertz Global against a short position in United Rentals on the belief that, over time, Herc will continue to execute and close the EBITDA margin gap between itself (in the mid-30% range) and higher-margin peers such as United Rentals (in the high-40% range). Herc is also a potential takeout candidate as the industry continues to be consolidated by United Rentals and Ashtead. Despite concern around slowing domestic growth, the team continues to believe Herc will out-execute its peers and de-lever its balance sheet over time, resulting in value accretion to shareholders.

With the market selloff in the final quarter of 2018, Water Island chose to shift the portfolio allocation to focus more on the harder, or more definitive, end of the catalyst spectrum. By year-end, approximately 74% of the portfolio’s long exposure was allocated to merger-arbitrage situations, via either equity or credit instruments. This marks a dramatic change from the third quarter (when merger-arbitrage situations represented just 48% of the portfolio), but the team believes caution is warranted as market volatility may well continue in 2019. Harder catalyst, shorter-duration situations such as definitive, announced mergers and acquisitions (M&A) inherently have lower correlation to market swings, helping insulate the portfolio during times of stress. In addition, in the softer-catalyst special situations sleeve of the portfolio, the managers are focusing more on credit-based opportunities, which tend to have a lower volatility profile than equity special situations. They also remain attentive to the long/short balance in the portfolio (though the fourth quarter presented a difficult market for finding short opportunities, with most of the event premium having been taken out of soft-catalyst names). The portfolio’s exposure is currently tilted more toward the long side, and a period of stability in the markets may be required before attractive short opportunities present themselves again.

Looking ahead, for the special situations sleeve, Water Island continues to see opportunities in speculative M&A, asset sales, and re-ratings. In addition, the spinoff calendar is full, with the number of announced transactions for 2019 already above average. A common theme amongst these situations is that companies are pursuing more simplified business structures; it appears the trend toward conglomeration has not been working. Spinoff names did underperform in the fourth quarter, though this now presents opportunities to get involved at more favorable entry points.

Lastly, the outlook for the merger-arbitrage strategy remains positive. Deal flow has been strong for several years and the team doesn’t anticipate activity subsiding. Technology and pharmaceuticals may prove particularly fruitful for continued consolidation. Private equity (PE) buyers also have massive amounts of capital sitting on the sidelines waiting to be deployed into future transactions. (The funds raised in the past two years alone represent nearly $1.4 trillion in buying power for potential M&A, depending on leverage ratios used.) While this capital was largely dormant during the fourth quarter due to volatility in the credit markets, PE buyers will likely re-enter the market eventually, lest they risk having to return money to investors and forego collecting management fees on unused capital. In addition, short-term interest rates have been on the rise. Rates typically act as a tailwind for merger-arbitrage returns, resulting in higher spread opportunities for arbitrageurs.

That said, regulatory issues remain a primary concern. Geopolitical uncertainties and the trade dispute between the United States and China continue to have the potential to impact the regulatory approval process, as the risk remains that regulatory bodies in China and the United States may be used to carry out political agendas. While such issues were prevalent for much of 2018, there is now an added wrinkle of the government shutdown in the United States, during which several key agencies will be forced to delay or are unable to process regulatory approvals for M&A. Nonetheless, while the team intends to remain prudent and disciplined in their approach, they are excited by the continuation of favorable conditions for all three of the primary driving factors of the strategy’s returns (interest rates are on the rise, deal flow is healthy, and there has been no shortage of volatility in the market).

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 December 31, 2018
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy

Bond Portfolio Top 5 Sector Long Exposures as of 12/31/18
Consumer Discretionary 12.6%
Media 10.2%
Energy 9.2%
General 8.7%
Technology 7.2%
Total 47.9%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 86 76
Average Credit Duration (yrs.) 4.6 4.6
Spread 178 bps 197 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 12/31/18
Non-Agency Residential MBS 52.9%
Agency CMO 9.9%
Commercial MBS 7.1%
ABS 6.0%
Agency Inverse Floaters 5.9%
Agency Inverse Interest-Only 5.7%
Collateralized Loan Obligations 5.1%
Bank Loans 4.6%
Municipals 2.5%
Agency PO 2.2%
Government 0.0%
High-Yield 0.0%
Cash -1.9%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 12/31/18
U.S. Stocks 44.6%
Foreign Stocks 26.5%
Bonds 4.1%
Other Asset-Backed 0.0%
Limited Partnerships 0.9%
Short Sales -2.3%
Exchange Traded Funds -2.3%
Cash 28.4%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 12/31/18

Long Total
Short Total
Net Exposure
Securitized 36.5% -0.8% 35.7%
Investment-Grade Corp. 20.4% -1.2% 19.2%
Bank Loans 15.4% 0.0% 15.4%
High-Yield Corporate 11.7% 0.0% 11.7%
Dividend Equity 6.7% -3.5% 3.2%
Convertibles 3.1% 0.0% 3.1%
Emerging Market 3.0% 0.0% 3.0%
Global Credit 1.8% -0.5% 1.3%
Currency 0.8% -3.2% -2.4%
Risk Management 0.0% -4.5% -4.5%
Global Rates 209.8% -42.2% 167.6%
Subtotal
312.5%
-55.8%
256.7%
 
Cash & Equivalents
3.6%
0.0%
3.6%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 12/31/18

Long Short Net
Merger Arbitrage – Equity 63.1% -11.2% 51.9%
Merger Arbitrage – Credit 18.4% -0.5% 17.8%
Total Merger-Related 81.5% -11.7% 69.7%
Special Situations – Equity 11.2% -7.7% 3.4%
Special Situations – Credit 17.2% -0.7% 16.4%
Total Special-Situations 28.3% -8.5% 19.9%
Total 109.8% -20.2% 89.6%