Litman Gregory Masters High Income Alternatives Fund First Quarter 2019 Attribution
Amid the sharp first quarter rebound for the markets, the fund gained 4.13%. This return more than recouped the decline experienced in the selloff during the fourth quarter, which was the fund’s first quarter of existence. In the January through March period, the Bloomberg Barclays U.S. Aggregate Bond Index rose 2.41%, while high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index) gained 7.40%.
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. Short-term performance in particular is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns. 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.
The performance of the four individual managers and the overall fund was in line with our expectations during the first quarter. The two flexible credit managers protected capital during the fourth quarter “risk-off” downturn and opportunistically put cash to work in attractive opportunities. This buying benefited first quarter performance and should help feed future returns. In the Brown Brothers Harriman commentary below, a few new purchases are highlighted. Overall, both credit managers remain defensively positioned. The Ares Alternative Equity Income sleeve was also opportunistic during the fourth quarter decline and has rebounded sharply this year. Ares has been lightening up on their winners and utilizing their flexibility to position the portfolio more defensively while still achieving upper-single-digit yields. The Neuberger Berman out-of-the-money put-write option strategy performed well in the first quarter, managing to nearly keep pace with the returns of passive at-the-money put-write indexes despite having lower risk (due to writing out-of-the-money options). We think this reflects the benefits of the strategy’s actively managed investment approach. We continue to closely monitor the sub-advisors and remain confident the fund can achieve our long-term expectations.
Given that the fund is still young, we want to remind investors that the fund invests in diverse non-traditional sources of income and is intended to be a complement to traditional fixed-income allocations, seeking long-term returns that are significantly higher than core fixed-income with low correlation to core bonds and less interest rate sensitivity. However, it is willing to accept higher volatility over the short term, as the fourth quarter demonstrated. Over the long term, we believe returns will be comparable to high-yield bonds, but with lower volatility and downside risk because of the diversified sources of return and manager flexibility.
Quarterly Portfolio Commentary
Performance of Managers
During the first quarter, the two flexible credit managers, Brown Brothers Harriman and Guggenheim, gained 2.57% and 0.87%, respectively. Ares Management’s Alternative Equity Income sleeve rose sharply, gaining 15.7%, while Neuberger Berman’s Option Income strategy gained 4.68%. (All sub-advisor returns are net of the management fees charged to the fund.) Each of these sleeves performed in line with our expectations.
Ares Management. The first quarter of 2019 delivered strong returns across the board for capital markets, presenting a dramatic reversal from the conclusion of last year. Equity income assets have performed well year to date due to shifting Federal Reserve policy, better-than-expected earnings, and continued U.S.-China trade discussions. As a result, the Alternative Equity Income portfolio returned 15.7% net, outperforming the 13.95% return for the benchmark.
The business development company (BDC) market rebounded significantly in the first quarter as both equity and credit markets recovered from the technical downdraft in December. While BDC book values did decline as of December 31, 2018, due to the mark-to-market requirement of their assets, business fundamentals remained strong and investors overlooked the temporary declines in book value. As a group, book value for the fourth quarter of 2018 declined a mere 3%; however, of the 42 BDCs we closely follow, 67% beat consensus operating estimates and only 7% of the industry missed estimates. This was the highest percentage of earnings beats for the BDC industry in the past several years. In addition, credit quality remained excellent with a very low percentage of loans on non-accrual. Solid fundamentals point toward continued positive performance in the BDC space; however, with our BDC investments returning a robust 17.8% in the first quarter, we have taken a slightly more cautious approach. As a result, we have trimmed several of our individual BDC holdings and currently have 40% of the portfolio in BDCs. In the quarter the portfolio benefited from positive stock selection, but industry allocation relative to the benchmark was a negative. Our BDC investments increased 17.8% versus the BDC benchmark return of 14.3%; however, our 40% BDC weighting versus a 60% weighting in the portfolio’s custom benchmark led to negative 84 basis points (bps) of portfolio contribution vs. the benchmark.
The MLP/midstream market continues to show its operating leverage to the surging domestic energy production with the calendar fourth quarter of 2018 providing another quarter of nearly 20% year-over-year cash flow growth. Management teams continue to address corporate simplifications (e.g., elimination of LP/GP structure and electing as C-corps) and the elimination of burdensome incentive distribution rights. With the majority of the structure overhangs completed in the past two years, we look to fiscal year 2019 for a focus on modestly growing distributions, continuing to improve balance sheets, and funding the growth project backlog with a growing portion from retained cash flows. Valuations improved for the sector on average during the first quarter to 11.0x enterprise value to next 12-month adjusted EBITDA (earnings before interest, taxes, depreciation, and amortization), although this is still at a discount to the historical average of approximately 12.5x. In the quarter the portfolio benefited from positive stock selection and industry allocation relative to the benchmark. Our MLP investments increased 18.0% versus the MLP benchmark return of 16.8% and our 24% MLP weighting vs 20% for the benchmark also added to our positive relative performance. The MLP investments generated 120 bps in portfolio contribution vs. the benchmark.
The mortgage real estate investment trust (MREIT) industry generated dramatically different returns between the agency MREITs and the commercial MREITs in the prior quarter (fourth quarter 2018). Agency REIT book values declined 8.3% on average during the fourth quarter as MBS spreads widened significantly versus Treasury rates in the quarter. The widening spreads cannot be hedged effectively by the group (called basis risk), whereas changes in overall interest rates are effectively hedged if both mortgage rates and Treasury rates move together. The widening of agency spreads was caused by a negative reaction to Fed chair Jerome Powell’s comments in October when he said the unwind of Treasuries and mortgage-backed securities (MBS) was on “autopilot.” This caused mortgage rates to rise significantly in October and November and most of the book value declines occurred during those months. In mid-December the Fed raised rates 0.25%, but communication to the market indicated that future interest rate increases were likely put on hold. Since that announcement, we began to add agency MREITs to the portfolio for the first time since launching the strategy in 2016. Following further communications from the Fed in January designed to calm the markets about future rate increases, the agency MREIT book values have recovered about half of the fourth quarter 2018 decline in book value. We currently have 7% of the portfolio in agency MREITs. The commercial MREITs had book value declines of only 0.50% in the fourth quarter 2018 earnings reports and 63% of the industry met or beat earnings expectations. Given this stability, the commercial MREIT stocks did not decline much during the prior period, and as a result have not rallied as much as the agency REITs, BDCs, or MLPs in the first quarter of 2019. The lower volatility and current valuation have improved the relative value of the commercial MREIT sector, and therefore we have rotated some of our BDC investments into commercial MREITs. Our portfolio consists of 11% commercial/hybrid MREITs and 7% agency REITs, and we have a bias toward adding more REIT exposure at these levels. During the quarter, the portfolio benefited from positive stock selection but was slightly hurt by a lower industry allocation relative to the benchmark. Our MREIT investments gained 14.0% versus the MREIT benchmark return of 9.9%; however, our 17% MREIT weighting versus a 20% weighting in the fund benchmark led to negative 16 bps in portfolio contribution vs. the benchmark.
In late December of 2018, we rotated approximately 10% of the portfolio into closed-end funds (CEFs) given sharp discounts to net asset values during the last week of December following the swift technical dislocation in non-investment-grade credit. These CEF investments increased 9.2% in the month of January and we took the opportunity to harvest the profits on those investments. We decided to allocate that capital into preferred equity securities of MREIT and MLP companies. Analysis of the preferred stocks through the December dislocation found that in general the securities declined only 1%–4% peak to trough. With an average yield of 7.75%, we view the preferred securities as an attractive way to generate strong income with increased downside protection in volatile markets. Should another market dislocation occur, we believe the preferreds not only dampen volatility but could be opportunistically rotated into deeper-discounted BDCs, MLPs, and CEFs. Finally, we had an opportunistic investment in Compass Diversified Holdings (CODI), which declined 16.9% in the fourth quarter, but rebounded 17.3% in the first quarter of 2019. The combination of our opportunistic investments (CEF, preferred, and CODI) generated 1.66% of portfolio contribution versus no benchmark weighting to these asset classes.
While we are pleased with the strong rebound in our target markets in the first quarter, we have become more cautious on the investment opportunity set at current valuation levels. We currently have 10% cash in the portfolio, and when combined with an 8% position in preferred securities and 7% in agency MREITS (which is a counter-cyclical business model), we have approximately 25% of the portfolio defensively positioned. Despite the defensive bent, the portfolio is still yielding 8.5% (inclusive of the cash drag). Overall, we remain cautiously optimistic toward the U.S. economy as economic fundamentals remain strong despite being very late in the market cycle.
Neuberger Berman. Over the quarter, the Option Income portfolio returned approximately 4.7% (net of fees), which recaptured most of the losses suffered in the prior quarter. For the period, the S&P 500 and Russell 2000 indexes posted historically significant results of 13.65% and 14.58%. Despite focusing on out-of-the-money options, the portfolio managed to keep pace with the two at-the-money put-write index returns of 5.48% for the CBOE S&P 500 PutWrite Index and 4.92% for the CBOE Russell 2000 PutWrite Index. For reference, the Bloomberg Barclays U.S. High Yield Index returned 7.26% for the quarter, which was its best quarterly return since 2009.
The portfolio’s first quarter return comprised option gains of 390 bps split between S&P 500 option exposures (positive 335 bps) and Russell 2000 option exposures (positive 56 bps) and gains from the collateral portfolio of roughly 80 bps.
During the quarter, the CBOE S&P 500 Volatility Index (VIX) fell 46% from 25.4 to 13.7 and averaged 16.6 for the period. Realized volatility for the S&P 500 was 13.6 for the quarter, resulting in a positive average implied volatility premium of 3.0. Similarly, the CBOE Russell 2000 Volatility Index (RVX) declined 38% and averaged 19.5 for the quarter yielding a positive average implied volatility premium of 2.4.
The portfolio’s option strategy notional allocation remains near its strategic weights of 85% to the S&P 500 Index and 15% to the Russell 2000 Index.
Short-term U.S. Treasury yields (2-Year) declined 23 bps for the quarter. The collateral portfolio remains relatively fully invested in short-term U.S. Treasury bonds with an average duration of 1.3 years.
2018 was a lost year, but how quickly a quarter can make up for lost time. At this point, markets have been so good for so long that investors may be beginning to lose focus on how hard it is to make money over the long term, and pundits have become too accustomed to Fed intervention, making the future increasingly uncertain. How do you unwind a balance sheet of this size? How do you effectively manage an economy when rates are so low? How will American politics affect the Fed’s actions? The rest of the world is watching and reacting to the decisions the Fed makes. While it’s easy to extrapolate the current trends—the fourth quarter 2018/first quarter 2019 equity reversal only served to reinforce investors’ “buy-the-dip” mentality—and economic data and conclude the U.S. equity markets can continue to compound at a historically unprecedented risk efficiency, we believe the markets are down to a limited number of “options.”
Brown Brothers Harriman. The first quarter was a strong “risk-on” market for credit, on the heels of a violent “risk-off” market in the fourth quarter of 2018. Both the dismal fourth quarter market and the buoyant first quarter market were reacting to similar economic data but different assessments of the Federal Reserve’s posture. While Treasuries persistently priced in a recession, the credit and equity markets reversed course completely over the two quarters—classic bipolar “Mr. Market” behavior.
We are more active in markets like this, buying from fear and selling to greed. A good example is Sirius Group (6.6% yield to maturity [YTM], rated BBB). The portfolio added Sirius on four different occasions over the two quarters at prices of $85 in the fourth quarter and just over $88 in early February. These bonds are trading at $92 as we speak and still yielding close to six percent. Sirius is a global broker-market reinsurer operating in nine countries but writes about half of its premium in the United States. Ratings and credit pricing have suffered from its spinoff from previous owner White Mountain and the subsequent purchase by a Chinese private equity firm. However, management remains in place, and Sirius is now listed in the United States.
Tivity Health (8.3% YTM B+) is a leading provider of fitness, health improvement, and weight management programs. Its single-B loan has a rating we think is upwardly mobile due to its strong cash-generating businesses and the high likelihood of rapid debt reduction. It carries a yield of over eight percent at purchase.
Unlike the corporate sector, the asset-backed securities (ABS) sector experienced relatively little price turbulence in the fourth quarter, and a correspondingly modest recovery in the first quarter. Nevertheless, BBH was able to take advantage of wider spreads on several attractive first quarter ABS purchases.
Hercules Financial (4.8% YTM, A) issued its fourth securitization. Hercules is a business development company (BDC) lender, founded in 2003 and listed on the New York Stock Exchange. The firm specializes in lending to late-stage life sciences and tech firms, with a very low historical loss rate on its low loan-to-value loan portfolio. Hercules did experience some very unwelcome news as founder and CEO Manuel Henriquez stepped down in March after being implicated in the college admissions bribery scandal. Hercules, however, has a deep investment bench and long-standing CIO Scott Bluestein quickly stepped into the chief executive role. The bonds have been unaffected by the shuffle.
Stack Infrastructure, Inc. (4.6% YTM, A-) issued its first ABS transaction, secured by the company’s geographically diversified real estate portfolio of data centers. The collateral securing the transaction consists of the bulk of Stack’s holdings, six of eight data centers located in the largest data markets: Northern Virginia, Silicon Valley, Dallas-Fort Worth, and Chicago. Stack builds and leases data center space with power and cooling to tenants under long term contracts. The tenants own and maintain their equipment, pay the power costs, and have fixed “take-or-pay” contracts.
As you can see, the alternate fear and greed of the last two quarters have given us several new opportunities that should feed returns over the coming year and support the portfolio returns even as Treasury yields are decreasing.
Guggenheim. We have been concerned about growing recession risk and unattractive valuations within credit. Broadly speaking, the portfolio is positioned conservatively. While the Fed’s pause in monetary policy and overall healthy corporate fundamentals could lead returns for credit higher in the near term, we believe the longer-term outlook is negative. Any excesses that continue to build during this “Indian Summer” could make the downturn more severe. So we increasingly favor high-quality assets with a preference for government-backed securities. We have minimal exposure to corporate bonds, but what we do hold is higher quality and away from levered industries and companies with heavy capital expenditures, favoring strong cash flows and recurring revenue streams. Most of our credit exposure is high-quality securitized credit such as senior CLOs. We are also maintaining higher-than-typical liquidity, which will allow us to pick up undervalued credits during opportune times. However, with spreads compressing violently in the first quarter, and opportunity levels poor overall, it does not seem likely we will keep up the pace in the second quarter. Volatility comes and goes, we will be ready for it whenever it emerges again. As always, we shall keep hunting.
The fund’s allocation across the four managers is as follows: 32.5% each to Brown Brothers Harriman and Guggenheim Investments, 20% to Neuberger Berman, and 15% to Ares Management. We use the fund’s daily cash flows to bring each manager’s allocation toward their targets should differences in shorter-term relative performance cause divergences.
Sub-Advisor Portfolio Composition as of March 31, 2019
(Exposures may not add up to total due to rounding)
Ares Alternative Equity Income Strategy
Brown Brothers Harriman Credit Value Strategy
Guggenheim Multi-Credit Strategy
|Interest Rate Swap||-0.3%|
Neuberger Berman Option Income Strategy
|Equity Index Put Writing||100.0%|