Alternative Strategies Fund 2018 Performance Q&A
The most difficult test for an investor is to maintain discipline in the face of frustration or fear – to overcome the natural human tendencies that serve us well in the wild but poorly in modern investment markets.
Markets have been very challenging this year and, in many ways, frustrating, with years of rising U.S. stock prices followed by sharp recent declines and a return of volatility. We’ve gotten an increasing number of questions about the Litman Gregory Masters Alternative Strategies Fund, which has very strong relative and risk-adjusted performance, but lower absolute returns in recent periods. This has been frustrating to some shareholders, and as investors in the fund ourselves, we can appreciate that. We prepared the following Q&A to help shareholders – and advisors who own the fund on behalf of clients – consider performance in the context of what the fund is designed to do and the overall the market environment, and to set realistic expectations going forward. We welcome any further questions you may have.
Performance across the Morningstar Multialternative category has been disappointing, and though your fund is five-star rated i, the past three- and five-year returns are lower than we’d hoped. Why haven’t returns been higher?
It is important to remember that beyond diversification away from traditional sources of return, one of the core objectives in creating this fund was to invest with managers who bring an inherent risk-awareness to their investment approach, but who are also opportunistic and eager to seek higher returns when the opportunities are compelling.
We saw a flaw in the broader Multialternative space where an emphasis on low volatility, or “checking off the boxes” to include every alternative strategy seemed to outweigh consideration for potential return (with high expenses to boot). We created unique mandates for our managers that allowed them to take fuller advantage of their respective opportunity sets than in a single-strategy vehicle. In a sense, the ability to capitalize on return opportunities is a structural component of the fund.
So why haven’t returns been higher? During a period of high returns for risk assets like U.S. stocks, a fund like ours, with more diversified drivers of return (and managers who are likely to be more conservatively positioned when valuations are high, yields are low and spreads tight) is likely to lag by a meaningful margin, and that has been the case. But while somewhat disappointing in an absolute sense, the purpose of our fund is not to generate high returns during strong positive periods for stocks; rather it is to provide some diversification and generate what we consider to be good returns across market cycles.
An important way our managers seek to achieve this is by judiciously adjusting the level of risk they take relative to the potential reward. Prudence dictates taking less risk when compensation for that risk is subpar and opportunities are generally scarce.
The key point we want to make is that taking less risk as valuations become stretched and spreads tighten to historically low levels does not mean our managers are permanently wired for low returns.
That point is supported by the fact that performance since inception remains satisfactory at 4.25% annualized through the end of 2018, well above 3-month LIBOR (0.71%), the Bloomberg Barclays Aggregate Bond Index (2.18%), the Morningstar peer category average (1.15%), and the HFRX Global Hedge Fund Index (0.90%).
|Average Annual Total Return|
Quarter End Performance as of 12/31/2018
|Three Month||Year to Date||One-Year||Three-Year||Five-Year||Since Inception (9/30/11)|
Litman Gregory Masters Alternative Strategies Fund (Institutional Class 9/30/11)
Litman Gregory Masters Alternative Strategies Fund (Investor Class 9/30/11)
Barclays Aggregate Bond Index
Morningstar Multialternative Category Average
HFRX Global Hedge Fund Index
Russell 1000 Index
SEC 30-Day Yield1 as of 12/31/18 Institutional: 2.69% Investor: 2.44%
Unsubsidized SEC 30-Day Yield2 as of 12/31/18 Institutional: 2.59% Investor: 2.34%
1 The 30-day SEC Yield is computed under an SEC standardized formula based on net income earned over the past 30 days. It is a “subsidized” yield, which means it includes contractual expense reimbursements, and it would be lower without those reimbursements.
2 The unsubsidized 30-day SEC Yield is computed under an SEC standardized formula based on net income earned over the past 30 days. It excludes contractual expense reimbursements, resulting in a lower yield.
|As Of Date||4/30/2018||4/30/2018|
Net Expense Ratio (%)
Excluding Dividend Expense on Short Sales and Interest & Borrowing Costs on Leverage Line of Credit 1
|Total Operating Expenses (%) 3||1.66||1.90|
|Gross Expense Ratio (%)||1.75||2.00|
3 The Advisor is contractually obligated to waive management fees and/or reimburse ordinary operating expenses through April 30, 2019. The total net operating expense includes dividend and interest expense on short sales and interest and borrowing costs incurred for investment purposes, which are not typical operating expenses.
Net Expense Ratio Excluding Dividend Expense on Short Sales and Interest & Borrowing Costs on Leverage Line of Credit: MASNX 1.70%; MASFX 1.46%; does not include dividend expense on short sales of 0.16% and interest expense of 0.04%.
Performance data 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 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.comInvestment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced. The gross and net expense ratios can be found in the most recent Summary Prospectus (4/30/2018). There are contractual fee waivers in effect through 4/30/2018
It’s also important to note that the fund has had higher-returning years, as shown in the chart below, which speaks to the fact that the fund has been able to generate higher returns in environments with better opportunities (particularly on a risk-adjusted basis). We would contrast this to strategies and structures that inherently target low volatility and almost by definition produce low returns – a characteristic of much of the multialternative space that we disliked and that led us to create the fund back in 2011.
Litman Gregory Masters Alternative Strategies Fund [MASFX – Institutional Class]
v. Barclays Aggregate, HFRX Global Hedge Fund Index and Morningstar Multi-Alternative Category
- Performance figures for 2011 reflect data starting Sept 29, 2011 (inception date for LG Masters Alternative Strategies Fund)
- Performance figures for the Institutional Share Class of LG Masters Alternative Strategies Fund (MASFX)
The fund is down in 2018 – is this consistent with your expectations given its role as a diversifier, and what should we expect if markets continue to decline?
This has been an especially challenging period for investors. For example, a study by Deutsche Bank noted that 90% of the 70 asset classes they track were posting negative returns this year – the highest percentage of losers in the study’s 100-year history. This includes global stocks, which were down about 3% through the end of November, investment-grade bonds, down around 2%, Treasuries, TIPS, commodities, gold…there has been essentially no place to hide.
The S&P 500 dropped 19.37% from its high on September 20 to its low on December 24. Over this same period, the Masters Alternative Strategies fund lost 3.61%.
Our beta on the downside was a little less than 0.2, or one-fifth the decline in stocks, which is right in line with our long-term expectation. For the full year, the fund was down just 2.08%, while the Morningstar Multialternative category return was negative 4.77% and the HFRX Global Hedge Fund Index was down 6.72%.
The fund isn’t designed to have zero correlation to equity markets or to be an explicit hedge that gains when markets decline, but rather to have various return drivers and the flexibility to invest more capital in areas with higher risk-adjusted return potential. So while we aren’t happy about a flat to slightly negative return, the fund has met our expectations in this environment.
It’s important to appreciate that with market volatility and losses comes better investment opportunities for skilled managers, such as the ones with whom we are partnered. Not that long ago we wrote in an update that preserving capital and hopefully generating some level of positive returns while waiting for better opportunities to emerge may not feel great but would ultimately be rewarding.
We also noted that the path to getting to the better opportunity set would likely be uncomfortable for markets generally, which has proven to be the case this year (and may well continue). So all in all, we like how the fund is positioned, with plenty of lower-risk dry powder within our sub-advisors’ portfolios to be put to work more aggressively at higher expected returns. In the meantime, we expect the fund to continue to serve a beneficial role in our client’s and our own portfolios by mitigating downside experienced in other areas of a broader portfolio.
The focus on risk consciousness and conservatism has resulted in volatility below your expected range. Shouldn’t more of the “risk budget” be used to generate higher returns?
Part of generating strong long-term performance in the type of strategy we manage is avoiding large losses, which dictates being more conservative when there’s a dearth of attractive risk-adjusted return opportunities, thus preserving capital for investment at higher prospective returns in the future.
The fund’s volatility since inception has been low, as measured by a 3.12% annualized standard deviation. This is not much higher than the Bloomberg Barclays Aggregate Bond Index’s 2.75% standard deviation, and well below our stated long-term expected range of 4-8%. Two factors contribute to this: one is the low-volatility environment generally (thanks in part to quantitative easing), and the other is our subadvisors’ unwillingness to take on excess risk (including risk that isn’t captured by volatility measures) to chase returns.
However, we want to emphasize to investors that we didn’t design the fund to be a “no risk, no return” alternative product, or one that has no correlation to any traditional asset classes at the expense of generating returns. We don’t see much practical value in uncorrelated offerings that take almost no risk and generate almost no return. While the Alternative Strategies Fund does add a measure of diversification to a traditional portfolio, it’s not designed to be market neutral or completely uncorrelated to risk assets. (There are funds out there that are designed to fulfill that role. Our experience has been that for most investors, those types of funds are extremely difficult to stick with during periods like the last five to 10 years.)
Rather, we think we the fund can benefit investors through a blended approach of:
- accessing non-traditional drivers of return (e.g., the risk premium associated with merger arbitrage and other corporate events, and capturing the long-short spread between mispriced corporate credits) through disciplined and thoughtful implementation, and
- investing with highly skilled managers who have considerable flexibility within their mandates to shift capital to the best risk-adjusted return opportunities they see, as well as the proven ability and temperament to increase or decrease their exposures based on how attractive the environment is for their strategy.
Our subadvisors are not afraid to invest more aggressively when they see compelling risk-adjusted opportunities, and in fact they welcome the chance to add exposure when others are pulling back. We have seen this recently in merger arbitrage (Water Island) and Puerto Rican municipal bonds (FPA), to name a couple of examples. There are others, of course, such as energy-related high-yield bonds (Loomis Sayles and FPA) in late 2015/early 2016 and, most prominently, non-Agency RMBS (DoubleLine primarily, but also Loomis Sayles) going back to the fund’s inception.
Litman Gregory also has the flexibility at the fund level to tactically overweight managers whose opportunity sets are extremely attractive. We have done this once thus far in the fund’s life, when we overweighted DoubleLine at inception to take advantage of the massive dislocation in non-Agency RMBS. This decision added significant value over the subsequent two years, at which time we unwound the overweight.
In short, we know the fund has been fully capable of generating attractive absolute performance, both because we know the managers’ opportunistic mindset, but also because we have seen it in the fund’s live history (as reflected in the return chart shown earlier).
What is reasonable to expect looking forward from this fund? What will opportunities look like?
In assessing what to expect from Alternative Strategies Fund it is important to consider the broader investment outlook as it relates to the sources from which a position in the fund is likely to funded – namely a mix of bonds and stocks. At the time we launched the fund, we saw elevated macro risks, a muted outlook for economic performance, and low return potential from bonds due to low interest rates. Economic performance has in fact been sluggish throughout this lengthy recovery, but stock valuations have expanded, which is the reason for very strong performance from U.S. stocks. Those still-stretched valuations are the reason we believe strongly that return potential for U.S. stocks from this point forward are not appealing. For bonds, while rates have risen from historically low levels, we still see low potential returns there and risk from further rate increases, although the outlook for bonds has become more balanced.
In other words, the factors we saw when we launched the fund – elevated risk and low return potential from conventional financial assets like stocks and bonds – are very true today and are important reasons we enthusiastically own the Alternative Strategies Fund ourselves.
Turning to the outlook for the strategies included in the fund, we view the disruption we’re seeing in markets in recent months as a positive in terms of creating opportunities that our managers can take advantage of to generate higher returns. From our broad top-down view, we agree with our managers that it is still early to be very aggressive in aiming for higher returns at this point in the cycle, but we are getting closer. We have begun to see volatility return to even U.S. markets, catching up to the rest of the world’s unpleasant experience. Against a backdrop of extremely high valuations for U.S. stocks and tight spreads in credit markets, the combination of a slowing global economy, trade wars, rising rates and the reversal of unprecedented quantitative easing leaves us with the feeling that patience is warranted and will be rewarded. That said, we accept the possibility of continued “underperformance” relative to riskier assets if markets quickly resume their upward march.
On the credit side, with the sheer volume of corporate credit issuance, as well as its low quality, we (along with many others, including several of our managers) suspect that stressed corporate credit will become a compelling opportunity within a reasonably short time horizon, although we obviously can’t predict exactly when. Because of the nature of the fund’s subadvisors, we expect to be extremely well positioned for this opportunity.
Loomis Sayles has other sub-strategies within the sleeve they manage on the fund, but corporate credit is their particular strength. DoubleLine’s historical specialty has been mortgages, but they have strong teams covering corporate credit (they’ve recently made a meaningful allocation to bank loans in the fund), emerging markets debt, and other sectors to which the portfolio managers will allocate capital when they feel the opportunity sets warrant it. FPA also has the ability to invest in corporate (and mortgage related) credit, and has done so very successfully in the past. DCI has been hurt most of this year by the combination of low spreads, low volatility in credit markets, and the dramatic outperformance of lower-quality credit compared to higher-quality credit. All of those things appear to be at least beginning to change, which should remove the strong headwinds to DCI’s strategy.
In sum, we believe we are close to the end of an extraordinary cycle where prudence and risk management have largely been unrewarded, and we encourage investors not to invest solely by looking in the rearview mirror. There could be significant returns to be made in coming years, but preserving capital through a potentially turbulent period along the way will be critically important. We think the fund’s construct and the quality of its subadvisors positions it well to navigate a difficult period and then take advantage of the resulting opportunities. As a result, we are still highly confident in the fund, and remain significant investors ourselves across Litman Gregory.