Litman Gregory Masters High Income Alternatives Fund Fourth Quarter 2018 Attribution
The Litman Gregory Masters High Income Alternatives Fund was introduced on September 28, 2018. The fund’s objective is to generate a high level of income from diverse sources, consistent with the goal of capital preservation over time. In the fourth quarter, the Institutional shares fell 3.08%. During the same three-month period, the Bloomberg Barclays U.S. Aggregate Bond Index rose 1.64%, while high-yield bonds (BofA Merrill Lynch US High-Yield Cash Pay Index) declined 4.67%.
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. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The fund’s performance during this brief and volatile period was in line with our 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. We are pleased that the fund had dry powder to invest into the credit market dislocation, which should provide a base for attractive returns going forward.
Quarterly Portfolio Commentary
Performance of Managers
During the fourth quarter, the performance of the two flexible credit managers Brown Brothers Harriman and Guggenheim was essentially flat. Both preserved capital in a volatile period for credit. Ares Management’s Alternative Equity Income sleeve suffered a 12.2% loss amid a sharp equity market decline, while Neuberger Berman’s Option Income strategy suffered a 5.1% decline. (These returns are net of the management fees that each sub-advisor charges the fund.) Each of these sleeves performed in line with our expectations amid a sharp risk-off market environment.
Key performance drivers and positioning by strategy
Ares: The fourth quarter was one of the most volatile periods for corporate credit and equity markets in recent history as global economic concerns weighed heavily on investor sentiment. Markets were consistently impacted by a decidedly negative technical move, which was only exacerbated by angst in December around Federal Reserve policy, the U.S. government shutdown and general political turmoil, the seasonality of capital markets, and concerns of a decelerating economy. Led by a selloff and significant outflows in both the high-yield and bank loan markets, equity income sectors experienced a steep decline in market prices. Additionally, year-end tax-loss selling due to a high retail ownership base in our targeted assets exacerbated the downdraft over the period. As a result, the Ares Alternative Equity Income portfolio lost 12.2% net of management fees versus a loss of 12.6% for the benchmark, resulting in 0.37% in relative outperformance over the quarter.
Specific to the BDC (business development company) market, fears of a recession and weakness in the high-yield and leveraged loan markets spilled over into the asset class leading to the severe selloff. We reduced our exposure to BDCs in late November and early December following insights sourced across the Ares platform that the credit markets were beginning to show signs of weakness. With the portfolio weighted 43% to BDCs versus 60% to our benchmark, this underweight helped drive 0.78% of positive attribution. However, stock selection was less of a contributor to performance as we added to our positions in Apollo Investment and FS KKR, which experienced larger downdrafts than the rest of the market. Nonetheless, we believe these names were oversold and our ability to source these names at attractive discounts to NAV (net asset value) will provide meaningful upside in the early months of 2019.
Facing structural headwinds throughout 2018, the MLP (master limited partnership) market was unduly punished alongside the steep drop in oil from over $70 per barrel of WTI to $45 per barrel by year-end. Throughout the majority of the period, we remained overweight to MLPs with the view that the sector traded at excessively cheap valuations relative to strong historical volumes for midstream assets. Nevertheless, the perception that MLPs are fundamentally affected by the price of oil led to further outflows in the space. Moreover, December tax-loss selling put further pressure on the group. Overall, our MLP allocation led to negative 0.21% of underperformance versus the benchmark during the quarter. Our strong stock selection within the MLP bucket helped offset the negative attribution related to our overweight to the sector. In the final week of December, we sold 20% of our MLP holdings and rolled these proceeds into Kayne Anderson MLP Investment Company, a closed-end MLP fund trading at a steep discount to NAV. This investment had a strong recovery in value during the last week of December, which has continued into January.
The mortgage REIT (MREIT) sector fared better than both BDCs and MLPs as it remained more insulated from the broader market turmoil during the quarter. With interest rate hikes and the continued unwinding of the Fed’s balance sheet, we maintained a 0% exposure to agency REITs throughout the period. In regard to the commercial MREITs, we had an approximate 8% allocation to the sector versus 20% for the benchmark. We took the view that increased competition and spread tightening in the space would offset the rise in Libor. As a result of this underweight, combined with our exposure to New Residential, which declined 14.75% during the quarter, our MREIT bucket generated 1.24% of underperformance relative to the benchmark.
Closed-end funds (CEFs) were a bright spot in the portfolio as the space hit historically deep discounts to NAV in late December. In the final trading days of the month, we bought a number of attractive CEFs (Barings Global Short Duration High Yield Fund, DoubleLine Income Solutions Fund, and Eaton Vance Floating Rate Income Fund) which led to 0.05% of outperformance relative to the benchmark. Notably, we also purchased Compass Diversified (CODI) a publicly traded private equity company that declined 16.9% in the quarter. CODI has fully recovered its decline in January and is back trading at our cost basis.
In 2019, we expect continued solid fundamentals and a less active Fed should improve investor perceptions toward dividend-paying stocks. However, ultimate returns will likely be driven by market perceptions around the health of the U.S. economy. Specific catalysts including the repeal of the Acquired Fund Fees and Expenses (AFFE) ruling in the BDC space, demonstration of self-funding in the MLP space, and stable book values among agency REITs should provide ample opportunities for active investment in our targeted sectors. Given the current fundamentals and valuation we think it is reasonable to expect total returns in our sleeve in the 10%–15% range.
Brown Brothers Harriman: At the commencement of the strategy’s operations in October, we were unimpressed with corporate valuations. Our process is driven by a valuation framework that presumes credit spreads (the difference between a given credit yield and a similar-duration Treasury instrument) are mean-reverting. For much of 2018, corporate spreads were languishing at levels as low as they were just prior to the great financial crisis, meaning that our valuation framework deemed most instruments too expensive to purchase. As a result, our purchases focused on asset-backed securities (ABS), where we still found value and a few idiosyncratic value opportunities in corporates, while we maintained reserves (Treasuries and cash) for future opportunities. Investing in accordance with this framework has worked well for us in the past and certainly worked to protect capital during the first three months of the strategy’s operation. For example, investment-grade corporate indexes underperformed equivalent Treasuries by nearly 3% in the fourth quarter of 2018. Our shorter-tenor and higher-quality ABS holdings held up much better than corporate credit.
We are a credit-focused manager, and 2018, mostly on the back of the fourth quarter, was the worst year for credit since 2011. In this context of large negative returns across credit sectors, we are pleased that our portfolio return was about flat. We took advantage of these sagging markets to build our credit positions. We gradually increased our exposure to credit spreads one bond at a time as value returned to the market. Our current level of credit risk remains moderate, at 2.8 years of spread duration. (Spread duration is an estimate of how much the price of a specific bond will change when the spread of that individual bond changes.) For comparison, as spreads peaked in the last credit cycle we positioned our Credit Value strategy with almost five years of spread duration.
Our view of investment-grade corporate bond valuations is that they are mostly unattractive. Applying our valuation model, only about 25% of the investment-grade corporate index is trading at valuations that we would rate a “Buy.” (This number is up from about 4% earlier in the year.) Importantly, a “Buy” valuation suggests that we see not only compensation for credit and liquidity risk but spread compression potential above a cushion that we calculate for each sub-sector, rating, and duration. We must emphasize that any credit we buy must also pass our fundamental credit criteria. For fundamental reasons, we pass on many “Buy-valued” opportunities.
In contrast to corporates, we have continued to find good value in most sectors of the asset-backed securities (ABS) market. Foreign investors have not been active in this market, which means that it has been spared both the expensive run-up and the rapid decline seen in corporate valuations. However, ABS is a very issuance-driven market, and it takes time to build positions.
We remain unimpressed with valuations in agency mortgage-backed securities (MBS). MBS pools offer little compensation for the rate risk embedded within them and face technical headwinds as the Fed runs down its sizable MBS holdings. Furthermore, with fluctuations in interest rates, MBS change duration. Mortgages contributed nearly all of the +/- 0.5-year fluctuations to the Bloomberg Barclays U.S. Aggregate Bond Index in 2018. This volatility, in turn, can provoke a lot of trading, which is expensive in volatile markets, and impairs available liquidity for credit opportunities. For all these reasons, we’d like to be paid much more to own MBS.
We have believed for several years that longer-term rates do not compensate for the added rate duration exposure. As a result, the rate duration of the portfolio is only about two years, so that rate changes are unlikely to be a principal driver of returns. Rates rallied in November and December, and since the strategy’s benchmark has substantially more duration risk than our portfolio, benchmark returns exceeded our portfolio returns by about 1.78% in the quarter.
It is not surprising, given the sector returns cited above, that our Treasuries were the top contributor to performance, and that four of the top five contributing credits to performance were ABS. The bottom five contributors were all corporates and loans. While nearly all loans suffered significant price declines amid large withdrawals from loan funds, these names are now among the highest-yielding holdings in the portfolio.
As the year ended, the markets reflected overwhelmingly bearish sentiment. Forward rates implied a greater than 50% chance of a rate cut from the Fed by January 2020, and yields were inverted from one to six years on the Treasury yield curve. We expect our readers are familiar with what the stock market was doing at year-end. We believe this bearishness may be overdone. We were skeptical of the unbridled optimism in the stock and credit markets in 2017, and we are similarly skeptical of today’s pessimism. In 2017 and early 2018, we thought markets were underestimating the threats from
- erratic trade actions;
- increasing global debt;
- credit losses from an overheated direct-lending market in the United States;
- debt reckoning in China, or a China slowdown; and
- the rapid growth of U.S. student and automobile debt.
These remain potent threats to credit that have not materialized, though markets may be putting greater odds on one or more of them. Two important elements of our investing environment did change in 2018:
- A brief period of global synchronized growth ended
- And the U.S. government shutdown
We remind our investors that the vast majority of government spending—defense, entitlements, and a variety of other essential functions—continues on schedule. As we start 2019, we do not anticipate systemic danger from these discussed market changes, given the much stronger and less leveraged financial system. What is evident to us is the substantial disagreement between U.S. economic indicators and market sentiment as reflected in asset prices. Although the fourth quarter of 2018 was a volatile period, we welcome the more appropriate credit pricing heading into the new year.
From our perspective, bearish momentum is feeding on itself and markets are beginning to overshoot. This is what markets always do. What we at BBH always do is spend every working day looking for the next durable opportunity that is priced to outperform, not over the next month, but over the next few years.
Guggenheim: The U.S. economy expanded at a rate of about 3% in 2018, which we find to be roughly twice the pace needed to limit further tightening of the labor market. Tepid supply-side growth means the economy’s longer-run speed limit is lower than most people think, at around 1.5 percent, with corresponding equilibrium payroll gains in the neighborhood of just 95,000 per month. This implies that a big growth slowdown will be needed for the Fed to fulfill its “maximum sustainable employment” objective. Like most forecasters, we envision a slowdown in 2019, but we expect growth to remain above potential for most of the year, resulting in further tightening of the labor market.
With growth set to slow, the prospects for further rate increases have become more uncertain, particularly in light of recent market volatility. As the Fed enters a more data-dependent phase, we have changed our call for increases in the federal funds rate in 2019 from four to three. A key element of the change in our forecast is that wider credit spreads take some pressure off the Fed to raise the federal funds rate. Essentially the markets have done some tightening for the Fed, which limits the need for the Fed to hike as much. We expect that the Fed will deliver three hikes in 2019 and continue balance sheet runoff. Our work shows that balance sheet runoff equates to at least an extra 25-basis-point hike in both 2018 and 2019.
Yields on U.S. Treasury securities have fallen in recent months, but we expect higher yields in 2019 as the Fed delivers more rate hikes than the market is pricing in. We find that a terminal fed funds range of 3.00%–3.25% would translate to a terminal 10-year Treasury yield near 3.50 percent. As with the last hiking cycle, we believe the market is underestimating the terminal rate, which argues for maintaining an underweight duration stance. The weak links in the U.S. economy are corporate balance sheets that are burdened with too much debt. One aspect of this story that is underappreciated by markets is the deterioration in working capital management relative to the past cycle. Our analysis shows that corporations’ short-term liabilities are rising as they take longer to pay their suppliers. This trend increases the interconnectedness of U.S. companies and could worsen the next downturn.
As we approach the turn in the credit cycle, we continue to remain defensive by opportunistically moving up in credit and maintaining a reasonable liquidity buffer for picking up undervalued credits in periods of market weakness. Overall, ABS returns, driven by collateralized loan obligations (CLOs) and aircraft lease ABS, added to performance as carry helped offset moderate spread widening. CLO supply pressures have flattened the term curve for CLOs to the point where defensive short spread duration CLOs are now comparably priced to riskier longer-spread duration CLOs.
Non-agency residential MBS were a detractor at the end of the year as spreads widened across a variety of sectors amid a broader risk-off move. Although higher rates have caused housing demand to soften recently, longer-term trends of favorable demographics and limited near-term supply should continue to support housing valuations. We continue to favor shorter-maturity and structurally senior tranches for their lower potential price volatility, as well as passthroughs backed by seasoned credit-sensitive collateral types, which should benefit from improving credit fundamentals.
Regarding bank loan performance, it was not immune from the broad market selloff. As we move toward the later part of the credit cycle, we remain highly selective.
Looking ahead, our outlook is that market sentiment is dependent on the continuation of above-potential growth—an outcome the Fed cannot tolerate indefinitely, and economic history tells us we should not expect it. With this in mind, and with the guidance offered by our Recession Dashboard, we continue to reduce credit exposure in anticipation of a recession starting in the first half of 2020.
Neuberger Berman: The Option Income portfolio avoided a majority of the equity market losses incurred in the fourth quarter. The portfolio declined 5.14% (net of fees), which compares favorably with the 11.26% and 16.06% declines posted by the CBOE S&P 500 PutWrite Index and the CBOE Russell 2000 PutWrite Index, respectively. Further, the strategy outperformed the S&P 500 Index’s 13.52% loss and the Russell 2000 Index’s notable 20.20% decline. For reference, the Bloomberg Barclays U.S. High Yield Index fell 4.53%.
For the fourth quarter, the portfolio experienced a maximum drawdown (using daily returns) of approximately 8.7%, which was less than half the 19.3% maximum drawdown in the S&P 500 Index and far better than the 15.5% maximum drawdown in the CBOE S&P 500 PutWrite Index.
The portfolio’s fourth quarter return comprised option losses split between S&P 500 option exposures (negative 475 basis points), Russell 2000 option exposures (negative 130 bps), and gains from the collateral portfolio totaling 100 bps.
During the quarter, the CBOE S&P 500 Volatility Index (VIX) jumped over 100% from 12 to just over 25 and averaged 20.9 for the period. Realized volatility for the S&P 500 was 23.8 for the quarter, resulting in a negative average implied volatility premium of 2.8. Similarly, the CBOE Russell 2000 Volatility Index averaged 24.1 for the quarter yielding a negative average implied volatility premium of 1.7. In both instances these negative premiums created headwinds for the portfolio’s short option exposures.
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.
The collateral portfolio remains invested in short-term U.S. Treasury bonds with an average duration of 1.4 years and an average yield to maturity of 2.5%.
As we look forward to 2019, markets are starting the year with a VIX level that is over twice the level at the start of 2018. Uncertainty in U.S. corporate earnings expectations is increasing, and analyst views are diverging. Single-stock and industry correlations appear to be declining. Several global political controversies and trade policies have the potential to come to dramatic resolutions. The Fed’s rate plan has become more ambiguous after the end of 2018. There are a lot of things to debate in markets in the coming year, but we expect uncertainty will continue to rule the day.
The fund’s allocation across the four managers are as follows: 32.5% to both 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 December 31, 2018
(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
|Asset Backed Securities||23.5%|
|Interest Rate Swap||-0.2%|
Neuberger Berman Option Income Strategy
|Equity Index Put Writing||100.0%|