2017 Annual Shareholder Letter
Dear Fellow Shareholder,
The second half of 2017 capped yet another stellar year for U.S. stocks and global financial markets in general. For the full year, the S&P 500 Index gained 21.83%. Smaller-cap U.S. stocks, represented by the Russell 2000 Index, rose 14.65%. Foreign stock markets were even stronger, with the MSCI EAFE Index of developed international markets rising 25.03% (in U.S. dollar terms) and the MSCI Emerging Markets Index up 37.28%.
Core investment-grade bonds delivered positive returns as the benchmark 10-year Treasury yield ended the year little changed from where it began. The Bloomberg Barclays U.S. Aggregate Bond Index returned 3.54% for the year. However, shorter-term Treasury yields rose during the period (as the Federal Reserve raised rates three times), causing the yield curve to flatten considerably—the difference between the 10-year and 3-month Treasury yields ended the year near a 10-year low.
For the second half of the year, the Litman Gregory Masters Equity Fund and the Litman Gregory Masters Smaller Companies Fund both outperformed their index benchmarks, while the Litman Gregory Masters International Fund trailed its benchmarks. For the full year, the Equity Fund and Smaller Companies Fund performed in line with their respective larger-cap and smaller-cap index benchmarks, while the International Fund lagged. The Litman Gregory Masters Alternative Strategies Fund performed in line with its absolute risk and return objectives. 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 inception. Please see the individual fund annual reports for additional details and commentary.
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
We’re running out of superlatives to describe the U.S. stock market. This was the ninth consecutive year of positive returns for the S&P 500, tying the historic 1990s bull market and capping a truly remarkable run from the depths of the 2008–2009 financial crisis. Beyond that, 2017 stood out for its lack of market volatility or downside. It was the first year ever that the S&P 500 rose in every single month. The VIX index of expected volatility fell to an all-time low in the fourth quarter. By year-end, the market had rallied for more than 400 days without registering as little as a 3% decline—the longest such streak in 90 years of market history, according to Ned Davis Research.
The broad driver of the market’s rise for the year was rebounding corporate earnings growth, supported by solid economic data, synchronized global economic growth, still-quiescent inflation, and accommodative global monetary policies. U.S. stocks got an additional catalyst in the fourth quarter with the passage of the Republican tax plan, reflecting investors’ optimism about its potential to further boost corporate after-tax profits, at least over the shorter term. Looking ahead, the consensus outlook is for continued U.S. and global economic growth and little risk of a recession in 2018. Without a recession, an equity bear market is unlikely—although a 10% market “correction” can happen at any time, and a severe macro/geopolitical shock could cause a larger drop.
While the near-term fundamentals appear solid enough, and market price momentum is a powerful force, we remain concerned from our top-down and longer-term perspective about market valuations. History is clear that high valuations imply low future returns, when analyzed over five- to 10-year-plus time periods. Related to this, when an outlook becomes the strong consensus view, one should assume it is already discounted to a meaningful degree in current market prices. Along with many valuation indicators flashing red, investor sentiment indicators are now also hitting all-time highs.
None of this is to say the U.S. stock market can’t or won’t post another strong positive year in 2018. But our analysis suggests very low expected returns for the market index over the next five years, with a high likelihood of a bear market at some point during that period. Given this outlook, we think it is critical for investors to honestly assess their own risk tolerance and investment temperament, and to be invested in a portfolio consistent with and run by managers aligned with these personal attributes. This will enable them to remain disciplined and patient—during the good times as well as the inevitable challenging periods—meaningfully improving their odds of achieving their long-term investment goals.
Thoughts on the Funds
We want to reiterate that Litman Gregory’s top-down market and asset class views have no bearing on the Litman Gregory Masters equity funds. The funds’ positioning and exposures are entirely the result of the stock selection and investment decisions of the funds’ sub-advisors. A core principle of our funds is to select managers representing a diversity of investment approaches or “styles,” creating a well-diversified overall fund, while still getting only the managers’ highest-conviction holdings. We believe our sub-advisors are skilled stock pickers, with the ability to add value running a highly concentrated portfolio sleeve. But each manager has a distinctive investment process, and their bottom-up assessment of the reward-versus-risk within their investment universes will differ over time.
We see this currently in the Equity Fund and Smaller Companies Fund, where some of our managers are not finding many compelling investment opportunities and their cash position has built up as result, while others are fully invested and still finding stocks that meet their hurdle for inclusion in their Masters portfolio. With each manager sticking to their investment discipline and being highly selective, we believe their potential to outperform the index over the remainder of this market cycle and over the longer term is high, but their paths to doing so will certainly look different from each other. For example, with growth stocks experiencing an extended multiyear period of outperformance versus value, we wouldn’t be surprised to see that relative performance cycle turn in favor of our more value-oriented managers. But as always, the timing of such shifts is uncertain.
Moving to international stocks, our outlook is currently more positive than for U.S. stocks. Our top-down analysis suggests non-U.S. companies in aggregate, especially in Europe where the International Fund is significantly overweight, are under-earning relative to their long-term potential or normalized level. Unlike the United States, since the 2008 financial crisis, Europe has gone through a debt crisis, and a relatively slow banking-sector deleveraging that has crimped lending and demand. Our analysis suggests Europe’s recovery has lagged that of the United States and there is a strong case for international stocks outperforming their U.S. counterparts looking forward. Anecdotally, we see that European countries are implementing labor-market reforms and European companies are restructuring and becoming leaner—both should bode well for profits if the synchronized global economic recovery continues.
Finally, turning to the Alternative Strategies Fund, the year saw two changes to our sub-advisor lineup, with the addition of DCI in early July and the removal of Passport in late December. Founded in 2004, DCI is a corporate credit–focused investment firm that manages systematic, fundamental, quantitatively driven strategies. We are very enthusiastic about the long-short credit portfolio they are running for our fund. We believe their strategy can generate attractive risk-adjusted returns across a variety of market environments, with low volatility, low risk of significant drawdowns, and low or no correlation to the equity, high-yield, and Treasury bond markets, as well as the other strategies on the fund.
We believe there is a long-term strategic role in most balanced investor portfolios for a well-managed, all-weather, multialternative strategies fund. We think the potential benefits of such a position are particularly compelling in the current environment, given the poor expected returns implied by stretched stock market valuations and very low bond yields, not to mention a panoply of macro uncertainties, such as central bank policy unwinding (“quantitative tightening”). Over the past nine-year bull market, there has been little need for portfolio diversification beyond owning a mix of U.S. stocks and core bonds. But financial market history is a history of cycles: bull markets sow the seeds of bear markets, and vice versa; the valuation pendulum swings from one extreme to the other, driven by human herd behavior; asset classes that were once loved become hated, and vice versa.
Our Alternative Strategies Fund is not intended to track any market index. Based on each of the underlying sub-advisors’ portfolios, its current overall positioning is on the conservative side of the spectrum. But once volatility returns to the markets, we know there will be better opportunities for our managers to commit capital, and we believe they are well positioned to do so. We can’t predict exactly when, but with U.S. stock market valuations and market sentiment at or near all-time highs, we are confident our patience will be rewarded.
As always, we thank you for your confidence in the Litman Gregory Masters Funds. Our commitment and confidence is 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, 2017.
Jeremy DeGroot, President and Portfolio Manager
Jack Chee, Portfolio Manager
Rajat Jain, Portfolio Manager