Litman Gregory Masters Alternative Strategies Fund Second Quarter 2017 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 1.18% for the quarter ending June 30, 2017. During the same period, the Morningstar Multialternative Category gained 0.64% and 3-month LIBOR returned 0.29%. Year to date, the fund’s gain is 2.44%, while the category and LIBOR have returned 2.26% and 0.54%, respectively.i

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.

Quarterly Review

The fund’s performance over the first half of the year has been reasonably good, although obviously not exciting. As we’ve mentioned before, in times without an abundance of compelling opportunities, we expect our managers to remain fairly conservative and hopefully generate acceptable returns without stretching far out on the risk spectrum. This should allow them to be more aggressive when they’re being more richly compensated for committing your (and our) capital. That’s generally been what we’ve seen so far this year.

While it has been a fairly quiet year so far in terms of specific themes within the portfolio, there are a couple areas we’d like to highlight. First, we’re excited to announce the addition of DCI as a new sub-advisor on the fund as of July 10. DCI is a San Francisco–based, corporate credit–focused investment firm that manages systematic, quantitatively-driven portfolios of long-only and long-short credit strategies. The firm was founded in 2004 by a group of principals who had previously built a quantitative credit analysis business (KMV) that was subsequently sold to credit rating agency Moody’s. DCI will manage an absolute-return-oriented, long-short credit portfolio for the fund. We believe that DCI’s strategy can generate attractive risk-adjusted returns across a variety of market environments with low volatility and low risk of significant drawdowns, given its diversification and lack of reliance on credit market beta or interest rate movements to drive returns. Additionally, DCI is a strong complement to the existing lineup of sub-advisors because of its low correlation to the fund’s current strategies and should contribute to the fund’s ability to achieve its return, risk, and diversification objectives. See our full write-up of DCI.

Second, we would like to provide a brief update on sub-advisor Passport Capital. Following turnover at the firm, which coincided with disappointing performance, we have spent considerable time with Passport, including John Burbank and other senior investment and risk management professionals. Our assessment is that the firm has clearly made some missteps, but the current structure and strategy create a good chance to perform well going forward. The investment team has narrowed its focus to areas and sectors that have historically been the firm’s most profitable, the core investment themes are longer-term oriented and less reliant on getting specific political and economic event calls right (while still having macro conditions play a role), and the portfolio management process has been simplified but still incorporates quantitative analysis and risk management as key inputs. We have seen some positive data points recently, including the MSCI decision to put Saudi Arabia on its “watchlist” for potential inclusion in the MSCI Emerging Markets Index, a key element of Passport’s high-conviction position in Saudi stocks. We are cautiously optimistic about Passport’s ability to generate attractive returns going forward, although we continue to monitor the firm closely and recognize that due diligence is an ongoing process rather than something that ever reaches a definitive end.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 6/30/17
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
5.41 2.55 16.66 1.75
Total Cumulative Return
35.35 15.49 142.53 10.49
Annualized Std. Deviation
3.21 2.77 10.71 3.20
Sharpe Ratio (Annualized)
1.60 0.86 1.48 0.51
Beta (to Russell 1000)
0.25 -0.02 1.00 0.26
Correlation of MASFX to…
1.00 -0.13 0.79 0.82
Worst Drawdown
-6.94 -4.52 -12.41 -9.33
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.90
% Positive 12-Month Periods
86.89% 81.97% 95.08% 80.33%
Upside Capture (vs. Russell 1000)
31.63 8.02 100.00 21.07
Downside Capture (vs. Russell 1000)
27.64 -8.30 100.00 41.67
Since inception (9/30/11).
Worst Drawdown based on weekly returns
Past performance is no guarantee of future results

 

 

 

 

Quarterly Portfolio Commentary

Performance of Managers

For the second quarter, four managers produced positive performance and one produced a loss. DoubleLine’s Opportunistic Income strategy gained 2.41%, the Water Island Arbitrage and Event-Driven strategy was up 1.92%, the FPA Contrarian Opportunity strategy returned 1.86%, and Passport’s Long-Short Equity strategy was up 1.83%. On the negative side, the Loomis Sayles Absolute-Return Fixed-Income strategy declined 0.59%. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DoubleLine: The Opportunistic Income portfolio’s return of 2.4% outperformed the Bloomberg Barclays U.S. Aggregate Bond Index return of 1.5% in the quarter. The U.S. Treasury curve flattened, with 2-year yields increasing by 13 basis points (bps) and 10-year yields declining by roughly 8 bps. As a result of intermediate- to longer-term yields declining, the longer duration agency residential mortgage-backed securities (RMBS) performed well from a total return perspective. Amongst agency RMBS, fixed-rate collateralized mortgage obligations (CMOs) were the best performers as they benefited from strong price appreciation and modest interest income. Within non-agency RMBS, Alt-A bonds were the highest contributors to total return due to robust interest carry and improving valuations. Other structured credit sectors, such as collateralized loan obligations (CLOs) and commercial mortgage-backed securities (CMBS), contributed positively to performance as they benefited from spreads tightening.

The portfolio ended the quarter with non-agency RMBS still the largest allocation at about 58%, and other credit-sensitive areas (CMBS, CLOs, asset-backed securities, or ABS) at almost 10%. Cash was still fairly high at 11%, although down several percentage points from last quarter’s multiyear high. The portfolio ended the quarter with a calculated duration of almost 4.9 and a yield of 4.2%.

FPA: The FPA Contrarian Opportunity strategy performed fairly well (gaining 1.9%) in the quarter, again taking into account the sizable cash allocation the team still holds (43%).

Similar to last quarter, activity was fairly light. The managers added to Mylan, General Electric, Qualcomm, and Meggitt (a British aerospace company). CIT Group was trimmed as part of the position was tendered into the company’s Dutch auction at a healthy profit. Foresight Energy bonds were called by the company, also producing attractive gains for the fund. The team also added a small (approximate 1%) short position in the iShares Russell 2000 Exchange Traded Fund (ETF) as a hedge based on what they view as extremely stretched valuation in that index.

The top contributors for the quarter were Oracle, CIT Group, Citigroup, Aon, and United Technologies. The largest detractors were the Naspers/Tencent pair trade, Arconic, Cisco Systems, General Electric, and Regis.

The gross long exposure to equities remained very similar to the previous quarter at 54% (approximately 49% net), including 15% in non-U.S. companies. Credit holdings are down to 7% of assets. Financials remains the largest sector concentration at approximately 20%, largely comprising the same group of banks, as well as AIG, Aon, and Leucadia National. Technology and industrials, at about 11% each, are the other significant sector exposures. Technology continues to largely comprise high-quality franchises like Oracle, Microsoft, Cisco, and Alphabet (AKA Google), along with the new position in Qualcomm. Industrials include diversified blue chips GE and United Technologies, as well as a few aerospace-focused companies. The team continues to research a number of new ideas but is generally still finding valuations too rich to commit meaningful amounts of capital at current prices.

Loomis Sayles: The Loomis Sayles strategy posted a small loss for the quarter (down 0.6%), as modest gains in most of the portfolio were offset by losses in hedges and fairly significant negative performance (relative to the overall allocation) in equities.

Securitized assets, particularly ABS and non-agency RMBS holdings, contributed to performance during the quarter as fundamentals remained stable across all sectors and investor sentiment continued to be positive. Investment-grade corporate bonds also contributed positively as spreads tightened further during the quarter and ended the period near multiyear tights. The Macron victory in the French presidential election in early May reduced some political uncertainty, with positive effects for the asset class. Additionally, strong fund flows into investment-grade bonds, especially from non-U.S. investors, buoyed the market. Most of the positive contribution came from names in energy, communications, and technology.

High-yield corporate bonds also added to performance as spreads tightened during the quarter after a brief period of volatility in late April around the time of the first round of the French presidential election. The combination of a relatively patient Federal Reserve, improving credit metrics, strong earnings, and a general search for yield from non-U.S. investors continues to have a positive impact on the high-yield market. Individual consumer non-cyclical, electric, and capital goods names contributed the most to returns.

Risk management tools, primarily equity index futures and options, as well as interest rate futures, detracted from performance. The decline in longer-dated Treasury yields during the quarter resulted in losses from short positions in Treasury interest rate futures. U.S. equities continued to rally during the quarter, causing their hedges in the S&P 500 to weigh on return. In addition, lower oil prices again resulted in losses for the portfolio’s relatively small but energy-focused long equity allocation. The team remains comfortable holding these equities as they anticipate oil prices will inch higher over the next year. The portfolio’s largest net long allocations remain in securitized credit and high-yield corporate bonds, although the weightings are significantly lower than they have been in past quarters (both in the low teens as a percentage of net assets), consistent with the managers taking less risk as nearly all credit sectors have continued to rally.

Passport: Passport’s Long-Short Equity strategy rebounded during the quarter, gaining 1.8%. Equity longs contributed 2.7% while shorts detracted 0.6% (both gross). The largest contributing sector was emerging markets (comprising Chinese Internet names and Brazilian meat company JBS), adding 1.4%, with Alibaba Group Holding (contributing 1.4%) and Altaba (contributing 1.2%) also being the largest single-name contributors. “MENA” (Middle East & North Africa, three positions in Saudi Arabia) was also a material winner, adding 1.1%, with Saudi Basic Industries (contributing 0.6%) among the top five winners for the quarter. We were encouraged to see Passport’s strong conviction in the addition of Saudi Arabia to the “watchlist” for inclusion in the MSCI Emerging Markets Index be validated in June, helping to boost the returns of Saudi stocks. The firm believes there is material additional upside to the country’s market as economic reforms take hold and institutional investors are forced to pay attention, given the potential index inclusion. Energy was the main detractor (negative 1.0%) at the sector level, and Parsley Energy the most significant losing position for the quarter, costing the portfolio 1.1%. Passport remains confident in the longer-term prospects for the company and is maintaining the position.

From a portfolio perspective, the most significant moves made over the course of the quarter were reducing the growth bias, increasing the weighting in Saudi Arabian stocks to 25% by adding Al Rajhi Bank, and reducing short exposure in energy. As we mentioned last quarter (and briefly above), Passport is strategically focusing on fewer sectors; taking longer-term, concentrated positions in its highest-conviction ideas that are not dependent on short-term political events; and positioning to withstand short-term volatility. We think these are sensible changes for the firm, although success will ultimately be driven by execution. At quarter-end, the strategy was approximately 100% long and 45% short, with the largest net long sector exposures in MENA at 25%, Internet/technology at 16%, and emerging markets at 9%.

Water Island: The Arbitrage and Event-Driven strategy continued its steady performance with a return of 1.9% in the quarter. Merger Arbitrage was the best-performing sub-strategies of the portfolio, contributing 156 bps (gross) to returns. Additionally, Equity Special Situations (contributing 20 bps) and Credit Opportunities (contributing 52 bps) were both additive to returns during the quarter.

The top contributor in the portfolio was the merger-arbitrage investment in the NXP Semiconductors/Qualcomm deal. In October 2016, Qualcomm entered into a definitive agreement to acquire NXP Semiconductors for $47 billion. NXP shareholders and the investment community more broadly viewed Qualcomm's offer as underwhelming even at the time the deal was announced, and the semiconductor index has appreciated significantly since then. Since NXP shareholders believe NXP could trade above Qualcomm’s offer on its own, NXP has traded very tight to the current offer. Additionally, in May, hedge fund Elliott Management disclosed a stake in NXP. The potential for Elliott to agitate for a higher bid has highlighted possible further upside in NXP.

The biggest detractor in the portfolio was an equity special situations investment in Time. In November 2016, press reports suggested Time had rejected an acquisition offer from Edgar Bronfman, Jr. worth approximately $18 per share. With an activist shareholder lurking and reports in January that Meredith had also approached Time, Water Island established a core position earlier this year, believing a sale would be forthcoming given the strategic interest. Despite apparent interest in the sale process, in April, Time announced it would proceed with its own strategic plan instead of selling. The portfolio managers maintain a position in Time, believing that the market is undervaluing the company’s digital assets as well as the potential for Meredith to return. That said, the catalyst is no longer as near term nor “hard,” so the position has been trimmed.

Much of what the firm does across the event-driven spectrum stems from corporate consolidation. As such, they must consider what could spur consolidation in a given market environment. Technological change is a common driver of disruption and thus a catalyst for consolidation. In equity special situations, this has led to increased exposure to the technology, media, and telecom sectors in speculative mergers and acquisitions and re-rating situations. For credit opportunities, merger-related credit situations in financial services and energy continue to offer good opportunities, as well as long/short relative value and deep value opportunities in health care, retail, and autos. Finally, in merger arbitrage, the outlook is little changed from the past two quarters. The mergers and acquisitions pipeline remains robust, providing a healthy flow of high-quality, strategic deals. The team has observed strong runs of consolidation in technology and financials, which they expect to continue.

In addition to strong deal flow, another interest rate hike (or two) before year-end is possible, which could provide a tailwind to returns. However, volatility, another important driver of merger arbitrage returns, remains largely absent from markets. The end result is an average spread environment in the range of 4%–6%, which has been relatively stable through the first six months of the year. Water Island believes the key to success in coming quarters will be event selection and timing. Properly anticipating which events will encounter issues, quickly cutting or (ideally) avoiding problem situations, and entering trades at the right time will ultimately drive good risk-adjusted performance.

Strategy Allocations

As of the end of the second quarter, the fund remained weighted according to our strategic target allocation: 25% each to DoubleLine and Loomis Sayles, 20% each to FPA and Water Island, and 10% to Passport.

With the addition of DCI, effective July 10, the new strategic weightings are: 23% to DoubleLine; 17% each to FPA, Loomis Sayles, and Water Island; 16% to DCI; and 10% to Passport. We use the fund’s daily cash flows to bring the manager allocations toward their targets when differences in shorter-term relative performance cause divergences.

Sub-Advisor Portfolio Composition as of June 30, 2017
(Exposures may not add up to total due to rounding)

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 6/30/17
Cash 10.8%
Government 1.3%
Agency Inverse Floaters 3.9%
Agency Inverse Interest-Only 4.7%
Agency CMO 8.6%
Agency PO 2.5%
Collateralized Loan Obligations 1.1%
Commercial MBS 1.4%
ABS 4.3%
High-Yield 0.1%
Municipals 3.0%
Non-Agency Residential MBS 58.4%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 6/30/17
U.S. Stocks 38.6%
Foreign Stocks 15.0%
Bonds 7.0%
Exchange Traded Funds 0.6%
Other Asset-Backed 0.4%
Limited Partnerships 0.4%
Short Sales -4.8%
Cash 42.8%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 6/30/17

Long Total
Short Total
Net Exposure
Securitized 15.2% -1.6% 13.6%
High-Yield Corporate 13.3% -0.6% 12.8%
Investment-Grade Corp. 7.4% 0.0% 7.4%
Bank Loans 9.0% -3.7% 5.3%
Dividend Equity 5.8% -1.6% 4.2%
Convertibles 2.4% 0.0% 2.4%
Global Credit 1.3% 0.0% 1.3%
Emerging Market 3.9% -3.2% 0.8%
Global Rates 10.3% -9.0% 1.3%
Currency 0.2% -1.7% -1.5%
Risk Management 6.5% -49.5% -43.0%
Subtotal
75.3%
--70.9%
4.6%
 
Cash & Equivalents
37.3%
0.0%
37.3%

 

Passport Capital Long-Short Equity Strategy
Exposures as of 6/30/17

Sector Long Short Net
MENA 25% 0% 25%
Internet/Technology 24% -9% 16%
Emerging Markets 12% -3% 9%
Consumer Discretionary 14% -9% 5%
Financial 5% 0% 5%
Health Care 5% 0% 5%
Industrial 3% -1% 2%
Energy 8% -8% 0%
Materials 3% -1% -2%
Diversified 1% -14% -13%
Total 100% -45% 55%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 6/30/17

Long Short Net
Equity Merger Arbitrage 58.4% -13.1% 45.3%
Equity Special Situations 25.9% -21.7% 4.2%
Credit Opps/Special Sits 25.6% -2.1% 23.5%
Total 110.0% -22.0% 73.2%