Litman Gregory Masters High Income Alternatives Fund Second Quarter 2019 Attribution
The second quarter of 2019 saw continued gains across the equity and bond markets. The Litman Gregory Masters High Income Alternatives Fund gained 1.51% in the three-month period, compared to the 3.05% gain for the Bloomberg Barclays US Aggregate Bond Index and 2.57% for high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index).
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 High Income Alternatives Fund has faced volatile markets during its brief nine-month history. It faced a steep market decline in its first three months, and sharp snapback in the subsequent six months of 2019. In both market environments, the fund performed in line with our longer-term expectations. The fund 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 and less interest-rate sensitivity, but it is willing to accept higher volatility. 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. The correlation may be relatively high to high-yield bonds, though with significantly lower beta. Importantly, given the flexibility of the managers’ mandates, we expect the correlation to vary over time depending on the market environment and the managers’ positioning.
During the second quarter, the fund lagged core bonds, which rallied on economic concerns and in anticipation of accommodative central bank policies. The fund also failed to keep pace with high-yield bonds, which continued to rally. A strong rally in either market is not atypical, but for the market to richly reward both “risk-on” and “risk-off” positions at the same time is somewhat unusual. We don’t believe this will continue at the same pace for long.
Throughout the second quarter, our flexible managers have generally been positioned relatively conservatively on the risk spectrum and with low duration, which helps to explain why the fund has not kept pace with high-yield returns this year, and why it has even slightly trailed the performance of core bonds. (More on the managers’ positioning and outlook below.)
Though positioned somewhat defensively as of mid-year, the fund still has an attractive mid-single-digit yield plenty of “dry powder” to put to work during periods of volatility, which should provide a base for attractive future returns.
Quarterly Portfolio Commentary
Performance of Managers
During the second quarter, each of the four managers performed in line with our current expectations amid the risk-on market environment. The fund’s two flexible credit managers, Brown Brothers Harriman and Guggenheim, generated gains, while remaining cautious on overall credit conditions. Brown Brothers gained 2.23%, while Guggenheim rose 0.91%. Ares Management’s Alternative Equity Income sleeve generated a 1.40% gain amid a sharp equity market rebound, while Neuberger Berman’s Option Income strategy returned 2.29%. (These returns are net of the management fees that each sub-advisor charges the fund.)
Ares Management: The second quarter of 2019 provided modestly positive returns across our asset classes as economic concerns in May were reversed by easing Federal Reserve commentary in June.
The Business Development Company (BDC) market remained stable in the second quarter following the significant dislocation in the fourth quarter of 2019, and the subsequent robust rebound in the first quarter of 2019. In the fourth quarter, the BDCs saw their book values decline by 2.5% on average due to mark-to-market valuations at the end of December. With the rebound in the equity markets, we expected a corresponding increase in book values in the first quarter. Roughly half of the BDCs experienced a meaningful rebound in book value while the other half had either flat or further declines in book. The cohort that declined experienced some credit weakness in their portfolios with additional non-accruals and credit watchlist investments. While our portfolio avoided most of the names that exhibited credit weakness, we did have a 3% position PennantPark Floating Rate (PFLT), which experienced some new non-accruals and a 3% decline in book value. Nonetheless the BDC industry saw book values increase by 0.5% with a total economic return of 10.9% (annualized). We took advantage of the market weakness in May to add to high quality BDCs that traded down, and as a result, we currently have 48% of the portfolio in BDCs.
We made a significant change in our Midstream Energy exposure in May by selling half our positions across the portfolio. We believe recent tailwinds have now shifted to headwinds: 1) The export markets have been a driver of production growth since 2015 and drawn-out trade negotiations with China could be negative for domestic energy production; 2) E&P companies continue to face pressure from investors to show positive free cash flow alongside total rig count declines the past two months, particularly in the Permian basin; 3) Natural gas liquids per barrel pricing and crack spread pricing declined meaningfully in the second quarter, which could negatively impact Q2 earnings relative to consensus. These concerns, combined with a strong rebound in stock prices through the first four months of the year, led us to reduce our MLP exposure from 22% to 11% in mid-May.
The Mortgage REIT industry generated dramatically different returns between the Agency MREITs and the Commercial MREITs in the second quarter. Commercial MREITs continued their steady performance with solid first quarter earnings as credit quality remains attractive for the group. Commercial Real Estate values remain high and lending standards remain sound in terms of loan-to-value (LTV) and covenants. Loan pricing continues to decline, but the increase in LIBOR in December flowed through to higher earnings in the first quarter. Agency REIT book values rebounded in the first quarter by 2.2%; however, they did not reverse the 8.3% decline experienced during the fourth quarter 2018. The agency REITs came under pressure late in the quarter as the yield curve flattened dramatically when the long-end of the yield curve declined while 3-month LIBOR remained unchanged. Agency REITs use leverage based on 3-month LIBOR and invest in 15-year and 30-year fixed mortgages. The flat yield curve led to several dividend cuts in late May and June. We expect the yield curve will steepen through the second half of 2019 as the Fed begins to lower interest rates, which will directly reduce the 3-month LIBOR rate. Agency REIT stocks have rallied in late June and into July as members of the Fed voiced more dovish comments. Our portfolio consists of 11% Commercial/Hybrid MREITs and 7% Agency REITs, and we have a bias towards adding more REIT exposure at these levels.
We continue to have a cautious view on the markets and maintain a defensive position in the portfolio. We currently have 12% cash in the portfolio and when combined with a 10% position in preferred securities and 7% in Agency MREITS (which is a counter-cyclical business model), we have ~30% of the portfolio defensively positioned. Despite the defensive bent, the portfolio is still yielding 9.1% (inclusive of the cash drag). Overall, we remain cautiously optimistic towards the U.S. economy as economic fundamentals remain sound regardless of the lateness in the market cycle.
Brown Brothers Harriman: Rates rallied rapidly in the second quarter, along with nearly every credit sector in which we are active. Asset-back securities (ABS) continued to buck the trend, neither widening much last year nor rallying this year. Credit returns largely correlated to credit quality, although BBB corporate bonds outperformed Treasuries by more than BB corporate bonds. We believe both trends are consistent with the dominant dynamic determining credit pricing recently: the global hunt for yield. Driven by negative rates in their home markets and vanishing hedged yields in high-grade credit, Asian and European investors have moved down in credit quality but ignored ABS for regulatory and structural reasons. In the second quarter, the BBH sleeve posted a gain but lagged the 3.0% return for the Bloomberg Barclays US Aggregate Bond Index. This was largely the result of the much shorter duration of the portfolio (at about two years) versus the benchmark (at approximately six years duration). Contributing to returns were sector and rating exposure, and particularly corporate security selection.
Only two obligors had negative excess returns (negative one and negative two basis points each), and no positions had a negative total performance return in the second quarter. Most of these positions were either built or increased from December to February, when spreads had softened significantly. Sirius, Vistra, and Sprint were all detractors last December, but their rebound impact has been much bigger.
The allocation and positioning of our portfolio is driven entirely by the availability and intensity of value opportunities. In markets where opportunities are abundant, we tend to own longer, and potentially more cyclical, corporate credit instruments, CMBS, and high-yield bonds. These are sectors we view as more volatile, and prone to periods of intense mis-valuation. In rich valuation regimes like today, the portfolio will focus more on short ABS and corporates, as senior secured loans, which we view as lower volatility assets while still offering higher yields than on-the-run corporate credit.
In general, our credit exposure remains finance-heavy, as we have found buyable spreads in short bank paper and see many large banks as having relatively low credit risk today. Our longest-duration credit holdings are insurance companies. ABS are generally financial in nature, although they are diversified over collateral from many different industries, ranging from shipping containers to tax liens to drug royalties. We own very few traditionally cyclical credits (such as oil exploration and automobiles), which have performed very well in this market. The non-cyclical bent of our credit portfolio has hurt corporate security selection.
As of June 30, the portfolio holds just over 64% in corporate bonds and loans, just over 25% in ABS, 5.5% in CMBS, 1.1% in MBS and the remaining 4% or so in cash and Treasury Futures. While ABS underperformed corporate credit so far this year, the deteriorating values in corporate credit are likely to push us towards the shorter, higher-quality ABS sector, as well as into some shorter investment-grade corporate credit, at least until the next bout of volatility allows us to find longer corporate bonds at attractive spreads.
In terms of credit quality, 26.7% is BB-rated, 6.6% is B-rated, and the remainder is investment grade. Most of the high-yield exposure is in senior secured loan form. Large outflows from the loan market at the end of last year gave us an opportunity to pick up several loans at excellent prices. In addition, high-yield bonds are mostly priced at very unattractive levels right now, while loans, being less volatile and bearing less credit risk, can more easily pass our valuation criteria.
Guggenheim: The Indian Summer for risk assets turned out to be much hotter than we had expected after a rocky fourth quarter. High-yield corporates generated strong returns, while investment-grade corporates saw spreads tighten against falling Treasury yields, propelling further returns. As we anticipated, we have seen volatility increase in the second quarter, with corporate spreads moving wider.
Fanning the flames, the Fed has shifted into an easing bias given soft inflation data, a slowdown in foreign economies, and trade policy uncertainty. In order to cushion the economy, the Fed could cut rates up to three times this year. Fed cuts will provide some incremental stimulus to the economy, but fiscal stimulus turns to a drag in 2020, and there are limits to the expansion due to capacity constraints. Given the tight labor market, decelerating improvement in consumer confidence, flat yield curve, and weakening leading indicators, our forecasting tools point to a recession beginning as early as the first half of 2020. While we expect that the next recession will be about average in terms of severity, it could be more prolonged than usual given lack of policy space at home and abroad. The corporate sector could be hit especially hard, due to record high debt ratios.
Our portfolio has increasingly favored high-quality assets with a preference for government-backed securities. Within credit, we continue to stay up in quality via securitized credit. We maintain our duration underweight as some of the recent rally may have been overdone and interest rates may rise if economic data improve. We shifted most of the curve positioning out of the barbell to neutral with the benchmark after the three-month/10-year Treasury curve inverted in March for the first time since 2007. Additionally, as appropriate, we have established options positions to take advantage of increased steepening of the curve should the Fed ease or longer-term rates rise if the Fed fails to deliver on the rate cuts currently priced into the yield curve.
We remain underweight investment-grade corporate bonds versus the benchmark, consistent with our capital preservation strategy. Investment-grade corporate bond spreads retraced much of the prior quarter’s widening on the back of a dovish Fed, foreign demand, and a more stable macroeconomic environment. The strongest spread rally over a three-month period since mid-2016 has diminished some of the value that corporate bonds offered at the end of 2018. We expect spreads to widen later in the year as investors start to price in the possibility of a U.S. economic recession.
Abundant late-cycle signals suggest that the risk-reward of owning credit is unfavorable. We expect risk assets to suffer a severe bear market leading up to and through the next recession. As a result, our multi-asset strategy continues to maintain liquidity buffers that are higher than typical, which should allow us to pick up undervalued credits during more opportune times.
Neuberger Berman: For the quarter, the Option Income strategy returned approximately 2.3%, while the S&P 500 and Russell 2000 indexes posted gains of 4.30% and 2.10%. Meanwhile, for the quarter, the CBOE S&P 500 PutWrite and the CBOE Russell 2000 PutWrite indexes returned 2.44% and 5.79%, respectively. For reference, the BofA Merrill Lynch US High-Yield Cash Pay Index gained 2.57 in the quarter. The strategy’s total return came from a mix of option exposures (approximately 1.2%, with the majority from S&P 500 options) and the collateral portfolio (about 1.1%).
The portfolio’s option strategy notional allocation remains near its strategic weights of 85% to S&P 500 Index and 15% to the Russell 2000 Index.
Year-to-date through June 30, the VIX level has retreated 10.3 points from 25.4 at the start of the year, averaging 15.9 for the period. Meanwhile, volatility on the S&P 500 Index has realized at 12.6, leading to a positive average implied volatility premium of 3.3 year-to-date. Year-to-date through June 30, the RVX level has retreated 10.5 points from 28.5 at the start of the year, averaging 19.0 for the period. Meanwhile, volatility on the Russell 2000 Index has realized at 16.8, leading to a positive average implied volatility premium of 2.2 year-to-date. Quarter-to-date, 2-Year US Treasury Yields have declined 51 bps. The collateral portfolio gained a little over 1.1%, modestly lagging the 1.44% return of the ICE BofAML 1-3 Year US Treasury Index over the period (which is not surprising given the index’s longer duration).
The fund’s target allocations across the four managers are 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 June 30, 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||-0.4%|
Neuberger Berman Option Income Strategy
|Equity Index Put Writing||100.0%|