Litman Gregory Masters Alternative Strategies Fund Fourth Quarter 2016 Attribution

The Litman Gregory Masters Alternative Strategies Fund (Institutional Share Class) gained 1.17% for the quarter ending December 31, 2016. During the same period, the Morningstar Multialternative Category lost 0.13% and 3-month LIBOR returned 0.21%. For the full year, the fund returned 6.87%, while the Morningstar category and 3-month LIBOR gained 0.76% and 0.68%, 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 produced reasonable gains in the fourth quarter, and although the profit was not as large as the previous two quarters, it brought the year to a fairly strong conclusion. A number of the themes we have written and spoken about previously played out successfully this year. These included the recovery in high-yield bonds (particularly energy and commodity-related ones), which benefited the Loomis Sayles strategy, as well as FPA to a lesser extent; cheaply valued financial stocks, which rallied in the second half of the year and particularly sharply in the fourth quarter, boosting FPA’s portfolio; still-attractive opportunities in structured credit, which were a tailwind for both DoubleLine and Loomis Sayles; dislocated event-driven opportunities (e.g., Yahoo!-Alibaba); and thoughtful risk management, which helped Water Island efficiently capture spreads in merger arbitrage in a tricky environment and aided returns through credit and equity special situations without elevated volatility or significant drawdowns.

The good performance in 2016 certainly makes this update more pleasant to write than last year’s version; however, there is almost always more than one way to look at things. In reflecting back on the end of 2015, we were disappointed with the recent performance but optimistic about the level of opportunity and the potential to see a rebound in performance over a reasonable horizon, given the nature of many of the positions. As we (and many others) have noted, periods in the markets that feel bad, like late 2015/early 2016, are often the most fertile for establishing positions that will bear fruit over the coming quarters or years. Conversely, as we mentioned above, a lot (but not everything) went well in 2016, so we do not enter 2017 with as strong an idea about where returns are likely to come from this year. That does not mean that performance will necessarily be disappointing, as there is still some “juice left to be squeezed” from some of the same performance drivers, and we have no doubt the markets will offer up new opportunities to our managers. But the portfolio’s yield is a bit lower than it was a year ago, valuations are higher for most asset classes, investor sentiment is generally positive, and our sub-advisors are once again fairly conservatively positioned. We are not in the business of making predictions one way or the other but are merely trying to keep (and convey to our fellow shareholders) a balanced perspective on the fund’s performance, both in good times and not-as-good times.

Despite the overall “Trump rally,” there has been a very meaningful divergence in performance between different sectors within the U.S. market, and across countries and regions globally depending on the market’s perception of Trump’s impact in a particular space. This divergence on its own should create new opportunities for managers who do their research and valuation work well, but the opportunities will likely go well beyond these first order effects. As much as discussion of the Trump phenomenon has already been beaten to death, and we would prefer to avoid adding to the virtual ink spilled on the topic generally, we do think it is instructive to use the election to highlight the folly of the prediction game. Very few predicted Trump would win, and very few correctly predicted what the market reactions would be as it was becoming clear he was indeed going to win. Now that it has been over two months since the election, new consensus views have emerged (financials good! bonds bad!) that are priced into sectors and asset classes. Some of that will of course be right, but some will not. If the recent elections taught us nothing else, it should be to expect the unexpected, not to mention the resulting market reaction.

From our top-down perspective, there seems to be a fairly high degree of certainty (and mostly optimism) priced into U.S. financial assets at a time when there is the potential for myriad “unknown unknowns” to arrive on the scene. All of this is to say that, as always, we don’t know where tomorrow’s great investment opportunities will come from, but we’re as confident as ever they will come and that our managers will have the dry powder, temperament, and skill to take advantage of them.

Litman Gregory Masters Alternative Strategies Fund Risk/Return Statistics 12/31/16
 
MASFX
Barclays Agg Bond
Russell 1000
Morningstar Multi-Alternatives Category
Annualized Return
5.45 2.35 16.4 1.49
Total Cumulative Return
32.13 12.92 121.95 8.04
Annualized Std. Deviation
3.34 2.87 11.14 3.31
Sharpe Ratio (Annualized)
1.57 0.78 1.42 0.43
Beta (to Russell 1000)
0.26 -0.02 1 0.26
Correlation of MASFX to…
1 -0.12 0.79 0.81
Worst Drawdown
-6.94 -4.52 -12.41 -9.33
Worst 12-Month Return
-4.49 -2.47 -7.21 -6.9
% Positive 12-Month Periods
85.45 81.82 95.55 78.18
Upside Capture (vs. Russell 1000)
31.95 6.79 100 20.77
Downside Capture (vs. Russell 1000)
27.64 -8.3 100 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

During the fourth quarter, the FPA Contrarian Opportunity strategy gained 4.73%, the Loomis Sayles Absolute-Return Fixed-Income strategy was up 2.62%, and Water Island’s Arbitrage and Event-Driven strategy gained 0.59%. On the negative side, DoubleLine’s Opportunistic Income strategy declined 0.16% and Passport’s Long-Short Equity strategy was down 3.19%. (These returns are net of the management fee each sub-advisor charges the fund.)

For the full year, Loomis Sayles led with a return of 12.29%, FPA followed with a 10.20% return, and Water Island and DoubleLine produced solid positive returns as well of 6.10% and 6.04%, respectively. Passport lagged for the full year, declining 3.43%, with nearly all of the full-year loss coming in the fourth quarter. (These returns are net of the management fee each sub-advisor charges the fund.)

Key performance drivers and positioning by strategy

DoubleLine: DoubleLine’s Opportunistic Income strategy produced a small loss in the fourth quarter of 0.2% (net of the sub-advisor’s management fee), perhaps not surprising given the jump in the 10-Year U.S. Treasury yield during the quarter following Trump’s victory. Despite having a majority of the portfolio in more credit-sensitive assets and significantly lower duration than the Bloomberg Barclays U.S. Aggregate Bond Index (the portfolio’s duration was 3.0 at the start of the quarter), the agency residential mortgage-backed securities (RMBS) piece of the portfolio does have interest rate sensitivity. Still, the strategy was able to weather the storm fairly well, particularly when compared to “safe” core bonds—the Aggregate Bond Index was down 3%, its worst quarterly performance in 35 years.

Within agency RMBS, inverse interest-only securities were the best performers as high interest income returns helped offset some of the price declines experienced by the sector. On the other hand, the sectors with the highest duration profiles, such as inverse floating-rate securities and fixed-rate collateralized mortgage obligations (CMOs), were the largest underperformers for the period as they suffered the steepest price declines. Among non-agency RMBS, Alt-A bonds contributed the most to total return; though the sector did face some price declines, this was offset by high interest carry. Subprime bonds were the second-largest contributor, and Subprime was the sector with the highest absolute return, due to modest price gains in addition to robust interest income. Collateralized loan obligations (CLOs) and municipal bonds also contributed positively to performance. Commercial mortgage-backed securities (CMBS) detracted slightly from performance.

At quarter-end, non-agency RMBS remains the largest allocation in the Opportunistic Income portfolio, at almost 59%, and other credit-sensitive allocations (commercial MBS, CLOs, asset-backed securities, and Puerto Rico muni bonds) make up almost an additional 10%. As is typical, DoubleLine increased the duration of the portfolio slightly as rates rose, ending at almost four years. The portfolio held significant dry powder at year-end, with almost 11% in cash.

FPA: The FPA Contrarian Opportunity strategy produced strong gains (greater than 4.7%) again in the quarter. Top contributors for the quarter were concentrated in financials, including Bank of America, Citigroup, CIT Group, Leucadia National, and AIG. The healthy return is unsurprising since financials were the largest concentration in the portfolio at the beginning of the quarter (at slightly over 20%), as they have been for some time, and the sector continued to perform well following Trump’s electoral victory and the resulting expectations of a steeper yield curve and reduced regulation.

The largest detractors included names in industries perceived to be negatively impacted by the Trump victory including Thermo Fisher Scientific (health care), Cisco Systems (technology), Groupe Bruxelles Lambert, and both parts of the now-separated Alcoa business (Alcoa and Arconic). Following the health care sector’s poor performance post-election, the managers have spent a good deal of time looking at various companies across the different sub-sectors (e.g., pharmaceuticals, distributors, hospitals, medical equipment, insurance, etc.). So far, however, they have made only a few small purchases.

The managers re-established the Yahoo!/Alibaba pair trade by shorting Alibaba Group Holding during the quarter. Other notable activity included exiting some of the opportunistic energy and commodity-related positions that were established over the last two years. Halliburton stock, Suncoke Energy bonds, and certain Glencore bond issues were all sold at significant gains. Despite sales of some of the bond positions, credit holdings were still nearly 10% of the portfolio at quarter-end. Net equity exposure ended at around 53%, and cash remained a very substantial position (approximately 37%).

Loomis Sayles: The Loomis Sayles Absolute-Return Fixed-Income strategy delivered strong returns once again, gaining 2.6% in the quarter. Global rates tools (primarily interest rate swaps and futures) contributed to return. Most of the positive impact can be attributed to short Eurodollar futures and U.S. interest rate swaps, as Treasury yields steepened during the quarter in anticipation of the rate hike in December. The portfolio’s U.K. and Czech curve steepener positions benefited from steepening in the yield curves in those countries during the quarter.

High-yield corporate bonds added to performance as spreads continued to tighten during the quarter and finished at their lows for the year. Aided by a relatively dovish Federal Reserve, positive flows into the asset class, stable oil and metals prices, and a general dearth of yield, investors continued to allocate to risk assets, pushing valuations higher. Energy, telecom, and technology names contributed most to performance.

Risk management tools (credit default swap index, equity index, and interest rate futures) were beneficial, as the interest rate hedges that had been a drag on performance for much of the last two years performed well given the general rise in Treasury yields during the quarter. Despite having limited exposure to convertible bonds due to their potential high volatility, converts were a meaningful contributor, as the post-election rally in the U.S. equity market dominated the narrative during the second half of the fourth quarter. Energy, technology, and consumer non-cyclical names were the largest contributors.

Not surprisingly, investment-grade corporate bonds detracted from performance as spreads remained relatively flat during the quarter after consistently tightening for the better part of the year. Rising U.S. Treasury yields prior to the Fed’s rate hike in December weighed on longer duration corporates, ending the recent streak of positive returns. Most of the negative performance came from banking and telecom names.

The portfolio entered the quarter with almost zero empirical duration, given most of its exposure is in credit-sensitive areas and its hedges, which was beneficial given the rising rate environment. It remained similarly positioned at quarter-end. The most significant net exposures remain in securitized credit, investment-grade corporates, and high-yield corporates (which actually increased somewhat on a net basis as the managers reduced some of the associated hedges).

Passport: Passport’s Long-Short Equity strategy was down approximately 3.2% in the fourth quarter. Longs and shorts both generated negative performance (losing approximately 0.5% and 2.4%, respectively).

On the positive side, the Middle East/North Africa sector contributed more than 1.6%, driven by investments in Saudi Arabia that Passport re-established earlier in 2016. Alinma Bank and SABIC (a chemicals and metals company) were the main contributors. The investment team is very bullish on the Saudi positions for both fundamental and technical reasons, as the country is expected to be included in the emerging-market index within the next two years, which Passport expects will drive significant demand as the inclusion nears. U.S. financials (mostly initiated during the fourth quarter) were also positive contributors. Wells Fargo was the largest single contributor, adding about 0.5% to performance, although there are several other smaller positions (including AIG and large regional banks) that helped as well.

Passport’s investments in the basic materials sector lost 1.3%, primarily driven by gold miners. (After seeing negative changes in demand from India following a spike around their monetary change and lower financial/investment demand given market expectations of a stronger U.S. dollar, Passport not only sold their gold miners but is now short a different gold miner.) The largest detractors on the short side were their consumer discretionary sector positions (down 0.8%) and several index hedges (down 0.8%), which consisted of U.S. stock, high-yield bond, and emerging-market-country-specific shorts, as well as a diversified emerging-market index outright short position and put options that were purchased at very low implied volatility.

Passport’s main exposures have evolved from a year ago due to a number of factors, including the Trump victory in November, but a number of themes remain. These include net long exposure to Internet/technology stocks as the largest sector allocation, and short emerging markets (with the exception of the few sizable Saudi positions noted above, which have increased significantly over the course of the year). Newer themes include long U.S. financials and U.S. energy companies (particularly those exposed to the Permian Basin), and a shift to net short in consumer discretionary names. The portfolio also has very little in the way of significant factor exposures compared to last year, being only slightly long growth and momentum. Net equity exposure ended the quarter at 34%, with 90% long and 56% short.

Water Island: The Water Island Arbitrage and Event-Driven strategy gained 0.6% in the fourth quarter. Credit Opportunities was the best-performing sleeve of the book, contributing 57 basis points to returns (30 bps from Merger-Related Credit and 27 bps from Credit Special Situations). The Merger Arbitrage sleeve contributed 52 bps to returns during the quarter, while Equity Special Situations detracted a bit (down 27 bps). All sub-strategies were positive contributors for the year.

The top contributor in the portfolio for the fourth quarter was a merger-arbitrage position in Abbott Laboratories’ $30.6 billion acquisition of St. Jude Medical. In April 2016, Abbott—a U.S. pharmaceutical company—entered into a definitive agreement to acquire St. Jude—a medical devices company. The deal spread narrowed in the second half of the year on news that the companies had received antitrust approval in both the United States and China, and despite a short seller’s contention that St. Jude’s medical devices were easily hackable, Abbott reaffirmed its commitment to completing the deal. (The deal ultimately closed on January 4.)

The largest detractor in the portfolio for the fourth quarter was an Equity Special Situations investment in Imperva. Water Island first invested in the cybersecurity firm in July after Elliott Management, a hedge fund with a history of activism, announced they had taken a stake in the company. Water Island’s thesis included the likelihood that Elliott would become active, with the most likely outcome being a sale of the company. By September, shares soared on reported interest from several large potential acquirers. However, in the fourth quarter, Imperva announced that the sale had been put on hold as they sought a higher price, causing shares to fall sharply. Water Island’s analysis indicated that a near-term catalyst was unlikely to materialize, leading them to sell the position for a loss.

Heading into 2017, the new administration in Washington features prominently in investors’ minds. While it’s impossible to predict exactly what will unfold, Water Island expects a decidedly pro-business attitude, with the potential for regulatory rollbacks, meaningful changes in the tax code (such as tax breaks on the repatriation of overseas cash), and stimulus through fiscal spending. Furthermore, they expect this economic growth to lead to additional interest rate hikes. Several of these changes are likely to be positive for merger-arbitrage investing. Some areas where Water Island expects to see good opportunities include banking and energy. They expect growth-driven deal-making in banking if the regulatory burden is reduced as expected, since there is pent-up demand for consolidation in that competitive industry. On the defensive end of the spectrum, they believe there is a continuing need for consolidation among weaker energy companies just to survive. Despite the expectation of a generally attractive environment, the merger arb team is cautious due to the populist undercurrent in Washington.

The mergers and acquisitions (M&A) environment should also provide additional merger-related situations for the strategy’s credit sleeve. The credit team also anticipates a growing number of opportunities for long/short relative-value positions as rates, credit spreads, and market dislocations create significant mispricings. The Equity Special Situations sleeve remains focused on trying to reduce the effect of volatility on the portfolio by maintaining a healthy long/short balance and seeking investments characterized by shorter durations and harder (more likely) catalysts.

The portfolio’s cash levels were relatively elevated at year-end (under 70% gross long exposure) due to a number of events rolling off in the final weeks of the year, including the successful completion of deals in both the Merger Arbitrage sleeve and merger-related credit. The team anticipates investing this capital as new M&A activity picks up, which historically happens in the latter half of January.

Strategy Allocations

The fund remains 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. 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 December 31, 2016
(Exposures may not add up to total due to rounding)

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 12/31/16
Cash 10.8%
Government 1.6%
Agency Inverse Floaters 5.0%
Agency Inverse Interest-Only 7.2%
Agency CMO 5.5%
Agency PO 1.0%
Collateralized Loan Obligations 1.7%
Commercial MBS 0.8%
High-Yield / Other 0.2%
Asset Backed Securities 3.2%
Municipals 4.0%
Non-Agency Residential MBS 58.9%
Total 100.0%

 

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 12/31/16
U.S. Stocks 41.9%
Foreign Stocks 14.9%
Bonds 9.2%
Other Asset-Backed 0.6%
Limited Partnerships 0.4%
Short Sales -4.3%
Cash 37.3%
Total 100.0%

 

Loomis Sayles Absolute-Return Fixed-Income Strategy
Exposures as of 12/31/16

Long Total
Short Total
Net Exposure
High-Yield Corporate 26.2% -8.1 18.1%
Securitized 21.4% -0.6% 20.8%
Investment-Grade Corp. 14.1% -1.8% 12.3%
Currency 7.9% -13.9% -6.0%
Dividend Equity 7.3% -4.6% 2.7%
Bank Loans 6.3% 0.0% 6.3%
Emerging Market 4.8% -0.8% 4.0%
Convertibles 1.8% 0.0% 1.8%
Global Rates 34.7% -14.0% 20.7%
Global Credit 1.5% 0.0% 1.5%
Risk Management 0.2% -18.6% -18.4%
Subtotal
126.2%
--62.5%
63.7%
 
Cash & Equivalents
15.6%
0.0%
15.6%

 

Passport Capital Long-Short Equity Strategy
Exposures as of 12/31/16

Sector Long Short Net
Internet/Technology 19% -5% 14%
Industrial 16% -4% 12%
Financial 13% -2% 11%
MENA 12% 0% 12%
Energy 10% 0% 10%
Health care 10% -2% 8%
Consumer Staples 4% 0% 4%
Basic Materials 3% -1% 2%
Consumer Discretionary 2% -5% -3%
Utilities 0% -1% -1%
Diversified 0% -36% -36%
Total 90% -56% 34%

 

Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Long Exposures as of 12/31/16

Long Short Net
Equity Merger Arbitrage 37.7% -7.5% 30.2%
Equity Special Situations 17.8% -16.6% 1.2%
Credit (Merger Related & Special Situations) 10.0% -0.4% 9.6%
Total 65.5% -24.5% 41.0%