2018 Annual Shareholder Letter
Dear Fellow Shareholder,
In stark contrast to 2017, during which a global high tide lifted almost all asset classes, 2018 was an extremely difficult year to make money in the financial markets. Investors came into the year energized by the promise of continued synchronized global growth and soaring stock markets. By year-end, they were licking their wounds from the worst annual returns for global equity markets since the 2008 financial crisis. The S&P 500 Index dropped nearly 20% from peak to trough in the fourth quarter and ended the year down 4.4%, breaking its remarkable nine-year streak of positive returns. Smaller-cap U.S. stocks (Russell 2000 Index) fared worse, losing 11.0% for the year. Foreign stocks struggled too, with the MSCI EAFE Index of developed international markets dropping 13.8% and the MSCI Emerging Markets Index down 14.6%, thanks in part to a stronger U.S. dollar.
Core investment-grade bonds (Bloomberg Barclays U.S. Aggregate Bond Index), which typically perform well when stocks do poorly, also had losses through November. A strong rally in Treasury bonds in December enabled the core bond index to end the year with zero return (0.01%). Among major asset classes, only U.S. Treasury Bills had a return above 1% for the year, and after adjusting for inflation, the real return was negative as well.
For the year, the Litman Gregory Masters Equity Fund and the Litman Gregory Masters International Fund trailed their index benchmarks, while the Litman Gregory Masters Smaller Companies Fund outperformed. The Litman Gregory Masters Alternative Strategies Fund posted a small loss for the year, which is consistent with our expectations when equity markets are in sharp decline. The fund continues to have the highest risk-adjusted return (as measured by both the Sharpe and Sortino ratios) in its Morningstar Multialternative category, since its 2011 inception.
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.
Thoughts on the Bigger Picture
Beyond the magnitude of the stock market losses, what stands out about 2018 is the breadth of negative performance across almost every type of asset class and financial market. For example, over 80% of Morningstar’s investment “categories” were negative for the year, the highest percentage since 2008 (and 1994 before that).
The contrast with 2017’s strong market results is also striking. Most investment strategists expected 2018 would bring a continuation of the synchronized global economic recovery. The sharp market pullbacks in 2018 were contrary to the 2017 year-end consensus (just as 2017’s unusually strong returns were a surprise to many after a difficult 2016) and only reinforce our view that no one can consistently predict short-term market moves. (And as we write this in late January 2019, risk assets are sharply rebounding, with global equities posting their strongest start to the year since 1987.)
With volatility returning to the markets, it also reinforces the importance of maintaining a balanced and contrarian perspective: when an outlook becomes the overwhelming consensus view, you should assume it is already reflected to a strong degree in current financial market prices. Extremely high (or extremely low) asset prices and valuations are already discounting extremely optimistic (or extremely pessimistic) outcomes. Those circumstances can create opportunities for fundamental, valuation-driven, long-term investors such as ourselves and the managers on the Masters Funds.
We currently see such opportunities across foreign stock markets (Europe and emerging markets), as well as selected pockets among more cyclically sensitive sectors of the U.S. market. In contrast, given current valuations and yields, we expect sub-par annualized returns over the medium term from the broad U.S. stock and core bond indexes. As such, we view selected alternative strategies run by skilled, risk-conscious managers as likely to be particularly beneficial in this environment, as a complement to a traditional balanced portfolio. We also see attractive opportunities for active management within the fixed-income/alternative-income space, and we are excited to introduce a new Masters Fund with which to access these areas for our clients and ourselves.
Introducing the Litman Gregory Masters High Income Alternatives Fund
At the end of September 2018, seven years after we launched the Alternative Strategies Fund, we introduced our newest fund, the Litman Gregory Masters High Income Alternatives Fund. Combining our expertise and experience investing in non-traditional income strategies in our client portfolios and our access to top-tier managers, we saw an opportunity to build a distinctive, income-focused fund offered at a competitive fee.
We partnered with skilled, experienced managers running differentiated and complementary strategies that are not available as standalone public funds. Each manager offers access to non-traditional sources of income that clients may not otherwise own. The fund seeks to generate a high level of income consistent with capital preservation—meaning that we want to maximize income within the context of prudent risk management.
Our due diligence process was intensive. Ultimately, we selected four sub-advisor teams that we believe run compelling strategies that are diverse in terms of process and opportunity set, but similar in the goal of high-income generation and risk awareness.
- Ares Management is running an alternative equity income strategy focusing on business development companies (BDCs), mortgage real estate investment trusts (mREITs), master limited partnerships (MLPs), and selectively, credit-based closed-end funds trading at a discount to net asset value.
- Brown Brothers Harriman is running a credit value strategy, investing in fixed-income securities across a wide range of sectors, focusing on non-traditional asset-backed securities, commercial mortgage-backed securities, corporate bonds, floating-rate loans, and municipal bonds.
- Guggenheim Partners is running a flexible multi-credit strategy, investing across a wide range of fixed-income and other debt and senior-equity securities across the credit markets and credit quality spectrum.
- Neuberger Berman is running a fully collateralized option income strategy that systematically writes out-of-the-money put options on U.S. stock indexes, generating income from the receipt of option premiums and interest on its short-duration U.S. Treasuries collateral portfolio.
Given the composition of the fund, it does not fit neatly in a typical asset-classification box or asset allocation pie chart. Broadly speaking, we see the fund as a strategic part of an investor’s diversified fixed-income allocation, offering access to proven managers with expertise in non-traditional income markets and less-efficient niches. It should be an excellent complement to traditional core bond exposures and other income-oriented investments.
The investable fixed-income markets have become far more diverse over the last 10-plus years, particularly as banks and other lenders have pulled back from areas they had traditionally financed. This has created a huge opportunity for investors to fill those gaps. We think investors should take advantage of this increased opportunity set for both greater income and potential diversification benefits, rather than be constrained purely to traditional investment-grade fixed-income. This is especially true now, since traditional core bonds are subject to much higher interest rate risk, while offering historically low yields.
We believe the Litman Gregory Masters High Income Alternatives Fund offers a compelling opportunity for skilled, active managers to generate high income and attractive risk-adjusted returns in non-traditional income sectors.
As always, we thank you for your confidence in the Litman Gregory Masters Funds. Our commitment and confidence are reflected in the collective personal investments in the funds by Litman Gregory principals, employees, and the funds’ trustees of over $21 million, as of December 31, 2018.
Jeremy DeGroot, President and Portfolio Manager
Jack Chee, Portfolio Manager
Rajat Jain, Portfolio Manager
Jason Steuerwalt, Portfolio Manager