Litman Gregory Masters High Income Alternatives Fund Fourth Quarter 2019 Attribution
The fund closed out 2019 with a 1.44% gain in the fourth quarter. Comparatively, the Bloomberg Barclays U.S. Aggregate Bond Index was up only slightly (0.18%), while the ICE BofA Merrill Lynch US High Yield Cash Pay Index gained 2.61% in the same three-month period. For the full calendar year, the fund gained 8.37%, while the Aggregate Bond Index rose 8.72% and the high-yield index rose 14.41%. Since the fund’s inception (9/28/18), its annualized return is 3.99% compared to 8.27% and 7.18% for the Aggregate Bond and high-yield benchmarks, respectively.
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.
While the fund’s performance lags the two benchmarks over its brief 15-month history, we think there’s more to the story than the short-term performance numbers indicate. Last year was atypical in that there was a strong and simultaneous rally spanning “risk-off” Treasuries to “risk-on” equities. Specific to the credit markets, it was also atypical in that higher-quality outperformed lower-quality in a risk-on year. We do not expect a repeat of last year’s broad-based rally, nor do we expect similar levels of returns for the benchmarks given today’s low levels of starting yields.
The fund’s two flexible credit managers Brown Brothers Harriman (BBH) and Guggenheim posted quarterly gains but did not keep pace with their benchmarks over the calendar year. For the 12-month period, BBH returned 7.59% and Guggenheim gained 3.35% (after adjusting for management fees). Both managers were positioned relatively conservatively during the year, and prudence was not rewarded on a relative basis. Importantly, their positioning reflects a dearth of attractive credit opportunities, not macro predictions. Each team focuses on identifying investments that meet their fundamental and valuation criteria, adding value via security selection, often in less-efficient credit sectors such as non-traditional securitized credit. Looking ahead, we expect both managers to benefit from their capital-preservation mindset, losing less when credit sells off and being ready to opportunistically invest their “dry powder” when yields are higher.
Our equity-sensitive managers Ares and Neuberger Berman performed well in the fourth quarter and for the 2019 calendar year. The Neuberger Berman out-of-the-money put-write strategy had a quarterly gain of 3.18% pushing its annual return to 12%. This result was rooted in the strategy taking advantage of high implied volatility during (and following) 2018’s fourth quarter selloff, generating very high option premiums in the first quarter of 2019. Importantly, the strategy continued to generate attractive risk-adjusted performance over the course of the year even after implied volatility declined.
The Ares strategy posted a fourth quarter gain of 2.82%, taking their full-year return to 22.3%. Going into the fourth quarter the strategy had a relatively conservative posture. While the team believes the economy is on solid footing, it is concerned about broader equity valuations, and specifically about marginal credit weakness in some of the smaller BDC loan portfolios. During the year it reduced exposures to business development companies (BDCs) and master limited partnerships (MLPs) and at year-end held a 12% cash position, with another 10% in liquid, defensive assets that will serve as dry powder in the event of a market pullback. The strategy’s yield as of year-end remains attractive at nearly 8.5% inclusive of the cash position.
Looking ahead, it’s highly unlikely that last year’s broad-based rally will repeat. At current valuation levels, credit selection will be critical to performance. We believe the managers’ flexibility, broad opportunity sets, and risk-awareness will result in attractive long-term returns. The fund’s diverse non-traditional sources of income are an attractive complement to traditional fixed-income allocations, offering returns comparable to high-yield bonds with lower volatility and downside risk.
Quarterly Portfolio Commentary
Performance of Managers
During the fourth quarter, the two flexible credit managers, Brown Brothers Harriman and Guggenheim, gained 1.07% and 0.63%, respectively. Ares Management’s Alternative Equity Income sleeve rose by 2.82%, while Neuberger Berman’s Option Income strategy produced a return of 3.18%. (All sub-advisor returns in this report are net of the management fees charged to the fund.)
Ares Management: Capital markets continued to rally in the fourth quarter of 2019 due to stable macroeconomic data and corporate fundamental trends, combined with cooling trade tensions and accommodative central bank policy. Economic data contributed to market sentiment as the U.S. non-manufacturing purchasing managers’ index (“PMI”) rebounded in November while the labor market continued to show signs of strength. Earnings season surprised to the upside as 75% of the companies in the S&P 500 reported a positive earnings per share (“EPS”) surprise. Investors reacted jubilantly to trade-related progress, and the S&P 500 reached an all-time high on multiple occasions, following progress toward a “phase one” trade deal (expected to be signed in January) and the signing of the United States Mexico Canada Agreement (“USMCA”), a refresh of the 25-year old North American Free Trade Agreement (“NAFTA”). Central bank policy remained supportive for risk assets, the Federal Reserve (“Fed”) cut rates by 25 basis points in November while the European Central Bank (“ECB”) resumed its Corporate Sector Purchase Programme (“CSSP”). With a supportive macro backdrop, equity income markets closed 2019 on a high note with the portfolio generating almost 3% net return in the quarter. This cemented strong absolute and relative outperformance for 2019 of 22.29% net vs. the blended benchmark return of 21.98%.
Since we significantly reduced our exposure to midstream energy in May, the space has experienced a 20% price decline. Given this protracted selloff, we began adding to larger and higher-quality midstream operators in December. We anticipate 2020 will continue to be volatile within the midstream sector as investors grapple with a moderating growth trajectory of domestic energy production and shifting basin supply/demand imbalances (e.g., exploration & production (“E&P”) investors forcing management teams to reduce drilling budgets to show positive free cash flow, timing of pipelines coming online, etc.). Given this backdrop, we view 2019 will mark peak capital expenditures (CAPEX) spending for the midstream sector as management teams realign their project backlog for the shifting energy producers. We do not anticipate seeing a significant uptick in share buyback activity in 2020. However, the potential issue highlights a new dynamic for management teams in terms of best returns of capital for investors in an improving free cash flow environment as leverage remains manageable and distribution coverage on average exceeds 1.5x. We also highlight January and February have historically exhibited seasonally strong fund flows into the midstream space, which Stifel recently noted over 40% of total capital inflows from 2015 to 2019 have occurred in those two months.
In the fourth quarter of 2019, the top contributors to the portfolio’s performance were FS KKR Capital Corp (FSK) (+45 bps), AGNC Investment Corp (AGNC) (+34 bps), Two Harbors (TWO) (+32 bps) and Broadmark Realty (BRMK) (+28 bps). The top detractors were Enable Midstream (ENBL) (-19 bps), Plains All American Pipeline (PAA) (-13 bps), Western Gas (WES) (-13 bps), and TCG BDC (CGBD) (-9 bps). Our relative outperformance was primarily driven by an underweight to the midstream energy sector. While we were underweight to our target exposure to BDCs, which detracted from relative performance against our benchmark, this was partially offset by our allocation to mortgage real estate investment trusts (MREITs), as well as opportunistic closed-end fund exposure. Lastly, we'd note that due to the robust returns in our markets over the period, our high allocation to cash resulted in -42 bps of cash drag against our benchmark performance.
In regard to our outlook for 2020, we expect the U.S. economy will continue on sound economic footing and we expect modest earnings growth. However, we do have some concern about broader equity market values and as such we continue to maintain our defensive positioning. Our current portfolio positioning of 12% cash and another 10% in defensive preferred securities will allow us to take advantage of any market volatility. Even with the defensive positioning our portfolio still generates an attractive 8.4% total dividend yield inclusive of the cash position.
Brown Brother Harriman: The BBH sleeve of the fund returned 1.07% in the fourth quarter and 7.59% for the full year 2019. We are pleased to have posted such solid performance results for both periods. In the fourth quarter, the trend of generally expensive prices for corporate credit continued as spreads tightened 23 and 44 bps (basis points) across BBB-rated and BB-rated credit, respectively. For the full year, the BBH sleeve’s solid performance was achieved during a strong rally in U.S. Treasury yields, while continuing to carry just two years of duration. From an attribution perspective, strong sector and rating contribution from corporate credit easily overcame negative security selection experienced in the fourth quarter. The full year enjoyed both sector and rating, and selection contribution to achieve this result.
The top contributors included multiple insurance company credits that caught up to our investment thesis, and credits where fear abated around our health care exposures. The bottom contributors were largely affected by lower commodity prices in the energy and power pricing markets.
At the foundation of this strategy is the flexibility to invest across different segments of credit where we find the most attractive valuations. We traded more actively this quarter, finding more bond and loan opportunities in corporate credit at new issuance and in the secondary market. Descriptions of some new purchases for the quarter are provided below.
During the quarter we purchased the secured term loan of Innovacare (MMM Holding) at an attractive coupon of 575 bps over 3-month LIBOR for an 8.3% yield on this B1/B+ rated credit. The company is the leading health care insurance provider in its home market of Puerto Rico. The company has low starting leverage and an experienced management team. The buyout loan is well supported from a stable cash flow perspective as almost all revenues for the company derive from the U.S. federal government. The loan also benefits from a stronger covenant package than is typical for current loans in the market.
We initiated a position in Enable Midstream Partners LP, which is a mid-cap MLP owned primarily by two regulated utilities. The revenue base for this business is mainly derived from predictable and fee-based transportation contracts across multiple U.S. geographies. Management has maintained a low leverage profile and strong dividend coverage ratios. As oil and gas price declines impacted energy credits generally during the quarter, we were able to pick up this Baa1/BBB+ rated credit at an attractive spread of 323 bps for a 5% yield in the secondary market.
An interesting new position in the fund is a hybrid subordinated 30-year bond issued by Apollo Global Management. This debt issuance was rated BBB+ and is callable in five years with a coupon that will also reset every five years based upon the issue spread over the then 5-Year Treasury note. Apollo is A-rated at the senior parent company level and throws off significant cash flow across all its business lines from recurring management fees. We were comfortable with the structure of this transaction and found the spread of 308 bps for a 4.9% yield very attractive for a credit of this high quality.
Guggenheim: Risks are building in various areas of the fixed-income credit markets, particularly in corporate credit. We continue to focus on income and capital preservation in a market where the risk/reward tradeoff looks unattractive in many credit sectors. It is clear there is far more downside risk than upside potential in credit. Currently, investment-grade bonds stand at spreads near their historical tights, far from their widest levels. The story is similar for high-yield bonds: They currently stand at a narrow spread over the Treasury curve, not far off their historical tights, and over 1,600 basis points from their historical wides.
Our primary portfolio allocation strategy has been to focus on high-quality investments that will exhibit minimal spread volatility and stable returns under a variety of credit and rate environments. We expect investment-grade corporate spreads to remain rangebound amid an abundance of caution. With investment-grade 10s/30s credit curves at the steeper end of the range and continued appetite from foreign and domestic buyers, we should see strong support for longer-dated, high-quality bonds.
The two largest allocations of the portfolio are non-agency residential mortgage-backed securities (21.7%) and asset-backed securities (35.1%). Post-crisis residential mortgage-backed securities (RMBS) comprised only 10 percent of the market in 2016 but now comprise closer to 37 percent of the market. Post-crisis RMBS has maintained reasonably stable underwriting standards, while the credit-sensitive pre-crisis sector has exhibited ongoing credit improvements. These trends have contributed to a decline in the overall riskiness of the sector and a corresponding broadening of investor sponsorship. Although the shift in composition away from pre-crisis deals began with the re-opening of primary RMBS issuance in 2013, trading volumes remained stubbornly focused on the pre-crisis segment and only recently began migrating towards post-crisis tranches.
We remain constructive on the performance prospects for non-agency RMBS as borrowers continue to benefit from favorable consumer-credit and housing fundamentals, which should translate to stable credit performance of recent issuance and improving bond cash flows for pre-crisis deals. We continue to favor senior, shorter-maturity classes for their lower price volatility as well as selected credit-sensitive, pre-crisis passthroughs that should benefit from constructive credit fundamentals.
In structured credit, we remain focused on high-quality new issuance. Our thesis over the last 12 months to favor short, senior collateralized loan obligations (CLOs) has worked as expected.
While recession risk has receded for the time being, clouds linger on the economic horizon. As the Fed, along with the European Central Bank and Bank of Japan, once again are engaged in synchronous balance sheet expansion, history shows that in time the current liquidity risk in markets and the economy will ultimately come to an untimely end, and the forces driving the current excesses will dissipate once the liquidity spigots are turned off. It is only a matter of time.
Our conservative approach has resulted in positive returns but trailed many benchmarks that have reflected a higher risk profile over the past year. While these short-term results may disappoint, the discipline of behavioral finance will caution against short-term tactical bets at the expense of long-term performance. The risk/reward tradeoff still favors caution.
Neuberger Berman: In 2019, the U.S. equity index put-write strategy benefited from increased index implied volatility premiums, strong equity market returns led by the 31.5% return of the S&P 500 Index, and reasonable short-term U.S. Treasury rates. Somewhat surprisingly, the CBOE S&P 500 Volatility Index (“VIX”) averaged 15.4 for the year, which was slightly lower than its 2018 average of 16.6. Yet, the implied volatility premium earned in 2019 was markedly higher. Thus, the year-over-year 30-day realized volatility levels of the S&P 500 Index was remarkably different. Comparatively, the S&P 500’s average 30-day realized volatility for 2019 was approximately 12.5 while 2018’s average was 17.1. This lower realized volatility environment in 2019 yielded an attractive average S&P 500 implied volatility premium of 3.7 versus the 2018 average of
just 1.1, meaning that sellers of put options enjoyed a more favorable environment in 2019 despite a lower average level of the VIX.
For the quarter, the S&P 500 Index gained 9.07% which lagged the Russell 2000 Index's return of 9.94%. The CBOE S&P 500 PutWrite Index (PUT) gained 4.45% finishing slightly behind the CBOE Russell 2000 PutWrite Index (PUTR)'s return of 4.80%. For the year, the S&P 500 Index has produced an attractive return of 31.49%, substantially exceeding the 25.52% return of the Russell 2000 Index. Meanwhile, the PUT and the PUTR indexes returned 13.51% and 14.50%, respectively.
Quarter to date, the sleeve’s S&P 500 Index put writing strategy returned approximately 3.27% exceeding the 2.96% return of the PUTY (the CBOE’s 2% out-of-the-money put-write index, which is a much closer approximation of the sleeve’s implementation). Meanwhile, year to date, the sleeve’s S&P 500 Index put writing strategy has rallied approximately 12.05% exceeding the 10.53% of the PUTY index.
The CBOE S&P 500 Volatility Index ("VIX") increased a modest 1.2 points to end the year at 13.8, averaging 13.7 over the period. A realized annual volatility for the S&P 500 Index of 7.6 resulted in an estimated positive implied volatility premium of 6.1. On the year, the VIX level has fallen 11.6 points from 25.4 at the start of the year, averaging 15.4 for the period. Meanwhile, volatility on the S&P 500 Index was realized at 12.5, leading to a positive average implied volatility premium of 3.0 year to date.
Quarter to date, the sleeve’s Russell 2000 Index put writing strategy posted a gain of approximately 3.65% outperforming the S&P 500 put-write strategy. Year to date, the sleeve’s Russell 2000 Index put writing strategy has rallied approximately 12.28% capturing modestly more premium than the S&P 500 put-write strategy despite the underperformance of the Russell 2000 vs. the S&P 500 on the year.
The CBOE Russell 2000 Volatility Index ("RVX") slipped 1.8 points to end 2019 at 15.2, averaging 16.2 over the period. A realized annual volatility for the Russell 2000 Index of 11.0 resulted in an estimated positive implied volatility premium of 5.2. On the year, the RVX level fell 13.3 points from 28.5 at the start of the year, averaging 18.9 for the period. Meanwhile, volatility on the Russell 2000 Index realized at 16.6, leading to a positive average implied volatility premium of 2.3 year-to-date.
Over the quarter, 2-Year U.S. Treasury yields declined a modest 5 bps. The collateral portfolio gained approximately 0.48%, performing in line with the 0.44% return of the ICE BofA 0-3 Month US T-Bill Index over the period. Year to date, the collateral portfolio climbed approximately 3.11%, as 2-Year U.S. Treasury yields fell 92 bps, outperforming the ICE BofA 0-3 Month US T-Bill Index return of 2.21%.
The fund’s allocation 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 December 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%|