Litman Gregory Masters Alternative Strategies Fund Second Quarter 2018 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) declined by 0.03% for the quarter ending June 30, 2018. During the same period, the Morningstar Multialternative Category declined 0.05% and 3-month LIBOR produced a gain of 0.59%. Year to date, the fund has declined by 0.26%, while the category and LIBOR have returned negative 1.15% and positive 0.91%, respectively.

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 was basically flat during the quarter and almost unchanged on the year—down about a quarter of a percent after fees. This unremarkable performance isn’t what we aspire to achieve, but as we’ve noted many times, the fund is intended to be a low-risk multialternative option. Its flexible mandate allows, and in fact encourages, sub-advisors to “swing harder” when opportunities are prevalent, but the first priority is risk management. With that in mind, and zooming out to take a big-picture view of the investment landscape, we find the fund’s performance reasonable, albeit obviously well below what we expect to see longer term.

All appears to be well for investors narrowly focused on point-to-point returns for large-cap US equities, with the Russell 1000 Index up almost 2.9% through mid-year and household name large growth companies doing even better. However, given US valuations that are still stretched by almost any measure, continued Federal Reserve monetary tightening in the later innings of the economic cycle, and the first shots fired in what could develop into a full-blown trade war, we see quite a bit of risk that could prove damaging to the “real economy” and financial assets. In the second quarter, a sharp rebound in the US dollar inflicted damage on some emerging markets, while the political situation in Italy again reminded investors of the potential fragility of the construct of the eurozone and common currency. We fully recognize that there are always risks in the world (with the worst-case scenario usually not occurring), but given the fund’s mandate and generally unattractive valuations/yields, we’re very comfortable with our sub-advisors’ highly selective and patient approach to investing our shareholders’ capital.

Our managers have demonstrated the willingness and ability to invest aggressively when they believe their respective opportunity sets warrant it, and they’re currently finding investments to make on a selective basis: Water Island is still positive on the outlook for merger arbitrage but has also found attractive enough opportunities to shift some capital to equity special situations; DoubleLine’s duration is slightly lower and yield slightly higher than a quarter ago, while holding more cash; and Loomis Sayles similarly has a slightly higher-yielding portfolio with their lowest exposure in years to high-yield bonds. There are things to do, but they require work to find and research, as well as judgment in sizing and sometimes hedging.

We are not in an environment where prudent managers feel confident in “backing up the truck” on whole asset classes or strategies. We will again get to that point sometime, which will present great opportunities to generate returns going forward (although the process is likely to be bruising). It may even happen sooner than most expect. Until then, our sub-advisors are sticking to their discipline, looking for positions offering good potential returns with acceptable risks rather than chasing returns by making high-risk bets. We think this is the way to achieve strong risk-adjusted returns over the long haul.

AQR’s Cliff Asness said, “I used to think that being great at investing long term was about genius. Don’t get me wrong, genius is still good, but more and more I think it’s about doing something reasonable, that makes sense, and then sticking to it like grim death through the tough times.” While mindful that there is often a fine line between discipline and stubbornness, that resonated with us. It applies to investing generally and is certainly relevant here. We all want higher long-term returns, but in seeking to achieve them while also prudently managing risk, we will have to accept lower returns at times, difficult as it may be. We remain confident in our roster of sub-advisors and portfolio construction, and believe the fund is well positioned for an increasingly volatile future.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 6/30/18
 
MASFX
Bloomberg Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
4.86 2.10 16.34 1.79
Total Cumulative Return
37.72 15.03 177.79 12.74
Annualized Std. Deviation
3.05 2.72 10.35 3.17
Sharpe Ratio (Annualized)
1.44 0.64 1.49 0.46
Beta (to Russell 1000)
0.25 -0.02 1.00 0.27
Correlation of MASFX to…
1.00 -0.12 0.78 0.81
Worst Drawdown
-6.94 -4.52 -12.41 -8.21
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.08
% Positive 12-Month Periods
88.89% 80.56% 95.83% 79.17%
Upside Capture (vs. Russell 1000)
29.45 6.93 100.00 21.39
Downside Capture (vs. Russell 1000)
26.68 -6.68 100.00 41.95
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, three managers produced positive performance and two produced a loss. Water Island’s Arbitrage and Event-Driven strategy was up 0.68%, DoubleLine’s Opportunistic Income strategy gained 0.49%, and the Loomis Sayles Absolute-Return Fixed-Income strategy increased by 0.28%. On the negative side, the FPA Contrarian Opportunity strategy lost 0.17%, and DCI’s Long-Short Credit strategy declined 0.90%. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DCI: The Long-Short Credit strategy was down 90 basis points (bps) in the second quarter, with underperformance from the strategy’s credit default swap (CDS) long/short sleeve outweighing small gains in the bond sleeve.

After modest gains last year, the market environment has proved more challenging in the first half of 2018 and the sleeve is down about 2.2% (net) year to date. By construction, the strategy remains focused on individual credit selection—favoring firms with lower default risk (as measured by DCI’s proprietary default probability model) and improving fundamentals. In the second quarter, lower-rated, more stressed credits rallied notably and are now outperforming by multiple percentage points for the year-to-date period, which has been a drag on performance. Increased dispersion in credit markets and a renewed focus on credit fundamentals will increase the opportunity set for the strategy, and thus the potential for future performance.

DCI’s long/short portfolio saw small but steady negative alpha in the second quarter that accumulated to net losses. In the CDS sleeve, long positions in rentals and industrials, and shorts in energy, media, and technology, contributed to the negative performance. There were some offsetting credit selection gains in consumer retail, long health care, and short banks, but their overall magnitude was somewhat limited. The biggest gainers were long MBIA, Bombardier, and Tenet Healthcare, and short JC Penney and Deutsche Bank, while the largest detractors were long Avis, Hertz, and Xerox, and short Weatherford, Sprint, and Altice. The cash bond portfolio posted small gains on the back of long positions in energy, media, transport, and consumer goods. AMAG Pharmaceuticals, Calumet Specialty, Verisign, and Intelsat were the best performers; Match Group was the only notable detractor. The impact of the bond hedges was in line with expectations. The credit hedging subtracted a bit from performance as the underlying high-yield bond indexes climbed on the quarter. Rate hedges were a small net positive.

Strategy risk, as always, is concentrated in bottom-up credit selection within a roughly market-neutral framework. From a sector perspective, portfolio positioning was mostly steady and the portfolio continues to be underweight financials and highly levered telecoms, with overweights in energy and consumer durables.

DoubleLine: For the second quarter, the Opportunistic Income strategy’s gain of 0.49% outperformed the Bloomberg Barclays US Aggregate Bond Index’s 0.16% decline. The US Treasury curve flattened during the quarter as the 2-year and 10-year yields were up 26 bps and 12 bps, respectively. Agency residential mortgage-backed securities (RMBS) were the largest detractors from performance due to the rate selloff and inverse floating-rate securities were the worst performers within the sector. Non-agency RMBS contributed positive total return due primarily to interest income and stable to improving underlying fundamentals. Alt-A securities outperformed within the sector as prices increased. Other securitized credit sectors including collateralized loan obligations (CLOs), commercial mortgage-backed securities (CMBS), and asset-backed securities (ABS) also contributed positive performance due to interest income. CMBS outperformed within the sector as price increases added to total return. Cash continues to creep higher, reflecting DoubleLine’s cautious outlook and expectation for better investment opportunities going forward. Non-agency RMBS, while still the largest sector allocation at 52% of the portfolio, has declined by over 15 percentage points over the trailing three quarters, while other credit sectors (CMBS, CLOs, ABS) have nearly doubled, to over 11% of the portfolio. Duration declined by approximately half a year since the end of the last quarter to 4.4, while the yield increased very slightly to 4.1%.

FPA: FPA’s Contrarian Opportunity strategy declined very slightly (net of fees) in the second quarter. The top contributors for the quarter were dominated by technology names: Facebook, Alphabet, the Naspers/Tencent pair trade, and Microsoft. Some have been longtime holdings (e.g., Microsoft), dating back years to when it was considered a “boring,” old-tech value stock, while others have been part of a more recent effort to buy dominant, scalable, high-quality franchise businesses at reasonable prices. Kinder Morgan, a more traditional value play purchased in the first quarter, was also a top-five contributor. The largest detractors were a diverse group including Porsche, Arconic, Owens-Illinois, TE Connectivity, and Mylan.

The quarter saw a reasonable amount of activity, including new long positions in large tech and cable companies Broadcom, JD.com, Charter Communications, and Comcast. Wells Fargo was added on price weakness early in the quarter, modestly increasing the portfolio’s exposure to large US financials. European materials companies HeidelbergCement and Lafarge were also new additions during the quarter. The team added significantly to its position in Arconic, where they have been actively engaged with the company. Occidental Petroleum, Gazprom, and Rosneft were sold completely, while MMC Norilsk Nickel, Consol Energy, Navistar, Cisco Systems, and Microsoft were trimmed. With volatility returning to the market, the team continues to search for high-quality opportunities to add at attractive prices. They also still view high-yield bonds as unattractive given historically low yields and spreads to Treasurys.

The portfolio’s gross and net long exposure to equities grew slightly due to net purchases, with gross long exposure now over 70% and net exposure approximately 60%. The largest sector concentration remains in financials, with information technology, consumer discretionary, and industrial sectors following. These four sectors comprise roughly half of the equity portfolio. Credit holdings are 5.7% of assets and include a handful of small allocations to private middle-market loans, in addition to a few remaining corporate credits and the Puerto Rico municipal bonds. Cash is approximately 34.4%.

Loomis Sayles: During the quarter, the Absolute-Return Fixed-Income strategy produced a 0.28% gain. Equities contributed to performance as stock market volatility around the world pulled back during the quarter following spikes earlier in the year. Much of the positive impact can be attributed to positions in individual energy names amid higher oil prices. In addition, better than expected first quarter reports for some individual energy producers lifted investor sentiment and pushed their shares higher. Loomis remains constructive on their energy holdings, but will take profits and reduce positions as price targets are met, and will also limit downside with hedges.

As yield spreads tightened during the quarter, most asset classes posted positive returns as sentiment remained positive. Securitized assets, particularly ABS and CMBS holdings, generated positive returns as fundamentals remained stable across all sectors. Currency positioning also boosted performance mainly due to the short euro position, which performed as Loomis expected during the quarter, declining against the US dollar. Currency markets focused on the slowdown in European growth, albeit from robust levels. A number of economic indicators including industrial production and retail sales declined from their highs. Concerns around Italian politics also contributed to euro weakness. Meanwhile, valuation-driven mean-reversion trades in the portfolio, namely short the euro against the Mexican peso and against the British pound, had a muted impact as the peso and pound fell during the quarter. Political uncertainty in Mexico and moderation in economic activity in the United Kingdom weakened their respective currencies.

Exposure to global credits detracted from performance as positions in Argentina weakened during the quarter. Higher than expected inflation data combined with a declining Argentine peso continue to be a drag on sentiment. The country is currently seeking funding from the International Monetary Fund. Exposure to several names in the banking and energy space led the negative performance. Global rates tools, primarily sovereign bonds, interest rate swaps, swaptions, and futures, also weighed on performance. Exposure to sovereign issues had the most negative impact on returns. In a reversal of last year’s yield-seeking inflows to emerging markets, the rise in US Treasury bond yields made emerging-market bonds less attractive and outflows followed. While many positions were offset with currency hedges, which mitigated some of the impact, long positions in Argentinian, Mexican, Polish, and South African sovereigns weighed on performance.

Water Island: Water Island’s Arbitrage and Event-Driven strategy gained 68 bps in the second quarter. On a gross basis, the merger-arbitrage sleeve of the portfolio detracted a total of 15 bps from returns (negative 38 bps from equity merger arbitrage and positive 24 bps from credit-based merger opportunities). Equity special situations contributed strongly (positive 87 bps), while credit special situations were also slightly positive (positive 6 bps), leading to an overall contribution of 93 bps for the special situations sleeve.

The top contributor in the portfolio was an equity merger-arbitrage investment in the acquisition of Monsanto by Bayer. In September 2016, Bayer—a German multinational pharmaceutical, agricultural, and life sciences company—entered into a definitive agreement to acquire Monsanto—a US life sciences firm focused on agricultural products and solutions—for $66 billion. The combination would create the world’s largest agriculture company with leading positions in both seeds and pesticides. Given the complexity of the deal and consolidation in the overall agriculture market, it was not surprising to see this deal receive second requests from global regulators during the first quarter of 2018 (specifically US and European regulators). During the second quarter of 2018, the deal received both US and EU approval and was subsequently completed, leading to a positive contribution to performance.

The top detractor in the portfolio was an equity merger-arbitrage position in Qualcomm’s acquisition of NXP Semiconductors. In October 2016, Qualcomm—a US telecommunications equipment provider—agreed to acquire NXP Semiconductors for $53 billion. As of the first quarter of 2018, the deal had received regulatory approvals from all required jurisdictions except China. Approval from Chinese authorities appeared imminent when, in the second quarter, the transaction was caught in the crossfire of the ongoing trade dispute between the United States and China. With China initially refusing to approve any transactions involving the United States, investors subsequently ran for the exits, leading to a sharp decline in NXP’s share price and driving the deal spread wider. NXP’s share price has fluctuated wildly on the back of both positive and negative rumors about the deal. Water Island maintains conviction that China will ultimately approve the merger, but the team has reduced its exposure in order to trim risk in the portfolio.

Two major themes have recently been impacting the event-driven investing environment: the ongoing trade dispute between the United States and China, and the Department of Justice’s (DOJ) first attempt to block a vertical merger in over 40 years. The DOJ’s court case loomed over several pending deals, although AT&T ultimately emerged victorious against the DOJ and was allowed to consummate its merger with Time Warner late in the second quarter. The trade dispute continues to dominate headlines to this day, and its influence remains evident in a handful of deal spreads. As mentioned above, Water Island continues to believe transactions such as NXP/Qualcomm will ultimately be approved, though the daily news flow will likely contribute to continued volatility in the near term.

Nonetheless, the outlook for merger arbitrage remains favorable. Mergers and acquisitions (M&A) deal volume for the first six months of the year reached record highs and the Fed has raised interest rates twice already in 2018—and four times in the past 12 months—with further hikes likely. Combined with the return of market volatility, conditions for all three of the primary drivers of merger-arbitrage returns (deal flow, interest rates, and volatility) are favorable. On the special situations side, the firm continues to see opportunity in asset sales and spinoffs (the latter of which has a fairly robust pipeline through the end of 2018). The bulk of the current opportunities in credit-based investments on the long side are in short duration, hard catalyst events (e.g., M&A), and while softer catalysts such as stressed/distressed aren’t broadly attractive in the current market environment, they can present opportunities on the short side. Overall, while merger spreads remain compelling, the portfolio managers found an increasing number of special situations opportunities with attractive risk/reward over the course of the second quarter, including several short opportunities. As a result, the portfolio’s strategy allocation has shifted closer to the expected longer-term mix of 50% merger arbitrage/50% special situations (whereas the portfolio had ended the first quarter with an increased allocation to merger arbitrage).

Strategy Allocations

The fund’s capital is allocated according to its strategic target allocations: 25% to DoubleLine, 19% each to DCI, Loomis Sayles, and Water Island, and 18% to FPA. 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, 2018
(Exposures may not add up to total due to rounding)

DCI Long-Short Credit Strategy

Bond Portfolio Top Ten Sector Long Exposures as of 6/30/18
Energy 18.9%
Consumer Discretionary 11.1%
Technology 8.7%
Media 6.8%
General 6.1%
Materials 4.6%
Investment Vehicles / REITs 4.5%
Transportation 4.2%
Consumer Non-Discretionary 3.7%
Pharmaceuticals 3.2%

 

CDS Portfolio Statistics:
Long
Short
Number of Issuers 90 81
Average Credit Duration (yrs.) 4.5 4.6
Spread 152 bps 160 bps

 

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 6/30/18
Cash 15.2%
Government 1.1%
Agency Inverse Floaters 5.1%
Agency Inverse Interest-Only 2.7%
Agency CMO 8.2%
Agency PO 2.0%
Collateralized Loan Obligations 3.1%
Commercial MBS 3.0%
ABS 5.1%
High-Yield 0.1%
Municipals 2.0%
Non-Agency Residential MBS 52.4%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 6/30/18
US Stocks 47.1%
Foreign Stocks 25.6%
Bonds 4.5%
Other Asset-Backed 0.3%
Limited Partnerships 0.8%
Short Sales -8.4%
Exchange Traded Funds -4.5%
Cash 34.4%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 6/30/18

Long Total
Short Total
Net Exposure
Securitized 31.0% -0.8% 30.3%
Bank Loans 13.7% 0.0% 13.7%
Investment-Grade Corp. 15.4% -0.4% 15.0%
Dividend Equity 8.4% -5.2% 3.3%
High-Yield Corporate 4.9% -1.8% 3.1%
Currency 2.2% -0.5% 1.7%
Emerging Market 5.8% -2.7% 3.1%
Convertibles 3.7% 0.0% 3.7%
Risk Management 0.0% -3.0% -3.0%
Global Credit 1.6% 0.0% 1.6%
Global Rates 103.2% -23.5% 79.7%
Subtotal
190.0%
-37.8%
152.2%
 
Cash & Equivalents
9.3%
0.0%
9.3%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 6/30/18

Long Short Net
Merger Arbitrage – Equity 50.4% -6.7% 43.7%
Merger Arbitrage – Credit 8.9% 0.0% 8.9%
Total Merger-Related 59.3% -6.7% 52.6%
Special Situations – Equity 43.0% -37.1% 5.9%
Special Situations – Credit 9.1% -1.6% 7.5%
Total Special-Situations 52.1% -38.7% 13.4%
Total 111.3% -45.4% 66.0%