The iMGP Alternative Strategies Fund (Institutional Share Class) gained 1.39% in the second quarter of 2023. During the same period, the Morningstar Multistrategy Category was up 1.98%, the Bloomberg US Aggregate Bond Index was down 0.84%, and the ICE BofA 3-Month Treasury Bill Index returned 1.17%. For the first half of the year, the Fund was up 2.02%, compared to the category’s 3.07% return, a gain of 2.09% for the Agg, and a 2.25% gain for the ICE BofA 3-Month Treasury Bill Index.
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 that their original cost. Current performance of the fund may be lower or higher than the performance quoted. The Advisor has contractually agreed to waive a portion of the management fee through April 30, 2024. Performance data current to the most recent month end may be obtained by visiting www.imgpfunds.com.
The Alternative Strategies Fund’s 1.4% increase is certainly better than a loss, but it isn’t cause for celebration. The Fund is in the process of recovering from last year’s disappointing performance, but it has not happened as quickly as we would like. Despite this, we think we are still in the early stages of a performance recovery due to the “coiled spring” nature of several of the subadvisor portfolios. (The blended portfolio of DoubleLine and Loomis Sayles has a nearly 10% yield to maturity and duration of under five years.) We have previously detailed how attractive we believe the prospective returns for these managers are likely to be over the coming quarters, while acknowledging that there are likely to be bumps along the way. We have recently seen an example of a “bump” that has hampered performance somewhat. After starting to recover reasonably well earlier this year, Agency Mortgage-Backed Security (MBS) has been challenged by the extreme interest rate volatility related to the banking mini-crisis late in Q1, the resumption of yields rising across the curve (following the sharp bank-panic-induced-plunge) and the subsequent lack of demand/selling pressure from banks. Without demand from the biggest investors in the sector (banks and the Fed), asset managers and foreign buyers are forced to pick up the slack, but only at nominal spreads approaching levels seen in the Global Financial Crisis (GFC). This naturally impacts other areas of securitized products to varying degrees, and while some sectors have fared better than others, the same headwinds, as well as fear of negative performance in commercial real estate, have helped to delay what we still expect to be attractive performance from the fixed income portfolios. Spreads in many areas of securitized are still very high relative to their historical averages and relative to similarly rated corporate debt. We don’t know when it will happen, but when Fed rate cuts begin to feel more imminent and investors begin to exit the money market funds and short-term Treasuries that have become so popular, these spread sectors with high yields (some with a bit of duration) certainly seem likely to be beneficiaries.
Similarly, Water Island’s merger arbitrage portfolio, although it has taken a few lumps due to regulatory challenges this year, offers a very compelling annualized deal spread well north of 20%. As usual, we add the caveat that some deals do extend or even break, but with spreads at the highest levels seen since the GFC, prospective returns appear attractive. Higher rates and the unfriendly regulatory climate have set the stage for what could be a strong period for the strategy, especially considering the relative lack of success the FTC and DOJ have actually achieved in their challenges (as Water Island mentions in their commentary). We thus have substantial pieces of the portfolio where discussion of their opportunity sets can reasonably include ‘GFC’ references. Being fairly confident that we don’t face a similar risk of systemic financial collapse as we did back in 2008, this feels like a good indicator of the potential for attractive returns going forward.
Our tactical overweight to DoubleLine seemed to largely be working as intended in Q1, but given the phenomena mentioned previously, Q2 performance has not been kind to the move, as DoubleLine is now only the third best performer within the Fund for the year. However, our decision was not based on a two-quarter outlook, and since we are still expecting strong absolute and relative performance from that sleeve, we feel confident in maintaining the current weightings. Taking a glass-half-empty view of the situation, the two subadvisors who generated the strongest performance in the first half (FPA and Blackstone Credit) had the lowest allocations. With that said, we didn’t reduce them much from their strategic allocations because we know timing changes is difficult and markets can easily confound making even the most well-considered moves, especially in the short-term. More optimistically, the Fund is up more than 2% with relatively little contribution from what we viewed (and still view) as the segments with the best combination of absolute return potential and catalysts to drive performance. It was also gratifying to see DBi’s portfolio rebound strongly from the Q1 losses that were largely driven by the bank failures. This powerful diversifying strategy should make the Fund more resilient to different market conditions over time, despite early challenges.
As shareholders and managers, we are very excited about the Fund’s positioning, and look forward to reporting to you in coming quarters, hopefully detailing further (and larger) gains.
iMGP Alternative Strategies Fund Risk/Return Statistics 6/30/2023
|MASFX||Bloomberg Barclays Agg||Morningstar Multistrategy Category||HFRX Global Hedge Fund||Russell 1000|
|Total Cumulative Return||49.53||19.51||39.10||23.48||387.84|
|Annualized Std. Deviation||4.76||4.11||4.25||4.13||14.72|
|Sharpe Ratio (Annualized)||0.55||0.17||0.46||0.23||0.93|
|Beta (to Russell 1000)||0.27||0.07||0.26||0.22||1.00|
|Correlation of MASFX to…||1.00||0.33||0.90||0.86||0.83|
|Worst 12-Month Return||-10.04||-15.68||-5.71||-8.19||-19.13|
|% Positive 12-Month Periods||0.76||0.64||0.73||0.65||0.86|
|Upside Capture (vs. Russell 1000)||25.80||8.73||24.44||19.92||100.00|
|Downside Capture (vs. Russell 1000)||27.20||6.62||29.07||27.36||100.00|
|Upside Capture (vs. AGG)||74.86||100.00||62.83||40.41||233.20|
|Downside Capture (vs. AGG)||22.69||100.00||20.75||13.56||3.84|
|Past performance does not guarantee future results. Indexes are unmanaged and cannot be invested into directly.||||As of 06/30/2023 Since inception (9/30/11)|
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, five of six sub-advisors produced positive returns, led by the FPA Contrarian Opportunity strategy (+6.24%) and the DBi Enhanced Trend strategy (+6.00%). The Blackstone Credit Systematic Group’s Long-Short Credit strategy was also nicely positive, gaining 2.42%, while the Loomis Sayles Absolute Return strategy (+0.19%) and Water Island’s Arbitrage and Event-Driven strategy (+0.08%) were also in the black. DoubleLine’s Opportunistic Income strategy fell by 0.58%. (All returns are net of the management fee charged to the fund.)
Year to date through June 30, the returns are as follows: FPA up 10.86%; Blackstone Credit Systematic Group up 4.48%; DoubleLine up 3.07%; Loomis Sayles up 1.80%; Water Island up 0.53%; and DBi down 0.47%.
Key performance drivers and positioning by strategy
Blackstone Credit Systematic Group (DCI):
The Long-Short Systematic Credit portfolio returned 2.4% in Q2 and was notably positive even amidst the continued market cross currents, lifting returns for the first half of the year to 4.5%. The strategy has continued to build on a run of solid performance from last year.
Alpha performance was strong for the quarter, driven by the long side of the portfolio. Gains were led by long positions in consumer discretionary – especially travel related, including airlines and cruise lines – and also in durables, including homebuilders. Short positioning in financials also provided a boost as the market digested the failure of three U.S. banks and the rescue of Credit Suisse. Long consumer names, long technology names, and long energy names provided positive performance contributions amid the broad market updraft. Telecom, materials, and pharma were negative contributors, along with long positions in healthcare and an underweight in utilities.
The portfolio was well hedged over the period and so the macro footprint was limited. This was satisfying, given the continued propensity for market gyrations and large moves in interest rates. Portfolio performance was steady and the net security selection gains in the portfolio were broad‐based. With credit differentiation a market theme, the portfolio’s underweight to high‐default‐probability names and tilt into stronger credit quality has been particularly valuable and this has played out positively in both the corporate bond and Credit Default Swap (CDS) sleeves. Both sleeves made notable contributions to performance for the quarter.
Blackstone expects this positive alpha environment to continue and they view the market environment as supportive of future convergence in credit selection. With an economic retrenchment and profit slowdown still looming, a sorting of credit into winners and losers is looking likely and should provide ample opportunity for continued credit selection gains this year.
Since last Fall, the markets have been like a drunk stumbling across a highway. You watch an eighteen-wheeler barrel down and clench your eyes shut — only to open them seconds later and find that he’s still standing. Then it happens again. And again. And, to your utter surprise, you soon find that he’s standing on the other side. Here we are in mid-2023 and we have been grazed, not flattened, by a long list of economic eighteen wheelers: most recently, no regional or global banking crisis, no US debt default, no profits collapse, no “recession by June.” We’re still standing.
Now place yourself back in early January. The market gods tip you off: inflation will prove sticky and the Fed will keep hiking. With a wink and a nod, they tell you that the Two-Year Treasury, then 4.4%, will hit nearly 5% by mid-year. Armed with this inside information, would you have bet that the Nasdaq, decimated by higher rates last year, would rise nearly 40% by mid-year, a record? Or that value would underperform growth by 25%, a tad more than its historic rebound last year? Or that equities would simply ignore the bond market which, with the most inverted yield curve in five decades, has breathlessly screamed recession for months?
We have two observations. Hedge funds have been cautiously positioned this year and are up single digits. While this might seem paltry relative to the 14% gain in the MSCI World Index, should they have predicted an overnight frenzy in AI that added $5 trillion to tech stocks? On the other hand, those numbers do look healthy relative to the 1% return on the Bloomberg Global Agg – a disappointment given the unexpected headwind of higher rates. This clearly has been a year to manage risk and live to fight another day. Great investors sometimes put on a sensible trade and it doesn’t work out – statistical tails do happen, after all. Over time, sensible trades generate alpha. That’s our bet, at least.
Further, we would like to remind people about the math of drawdowns. Bold cap headlines on Meta and Tesla tout year-to-date returns of 140% and 113%, respectively – not that both, after 65% drawdowns last year, are down 17% and 27% over eighteen months. The current obsession with respectable yields on corporate credit – and a decent 3% total return this year – glosses over the 18% drawdown last year. Investing is a long game and our math should reflect it.
Performance and Positioning
The Enhanced Trend portfolio gained 6% during the second quarter. The Japanese Yen declined significantly in Q2 as a result of widening policy spreads; central banks globally continued to tighten while the Bank of Japan maintained its yield-curve control. An elevated short position in JPY contributed to performance. An enhanced short position in 2-year Treasuries further aided portfolio performance. Developed markets, ex U.S., declined sharply during May, hurting the portfolio’s quarterly performance, but were positive in April and June, somewhat muting May’s impact. A reversal in gold markets also detracted from performance.
The portfolio slightly outperformed the Bloomberg US Aggregate Bond Index return of -0.8% in the second quarter. US inflation moderated over the quarter, however, upward price pressure in services industries continues to garner the attention of policymakers. Concerns over the banking sector’s solvency were replaced with uncertainty regarding the debt ceiling and growing apprehension of a hard economic landing.
Interest rate sensitive sectors struggled as US Treasury rates ended the quarter considerably higher across the curve. Subsequently, Agency MBS and US Treasuries were among the worst performing sectors. Credit sensitive sectors were mixed, with corporate credit and Emerging Markets posting positive returns and Asset Backed Securities underperforming. High Yield and CLOs were the top performers for the quarter, as their shorter duration profiles and high level of interest income provided stability amidst interest rate volatility. Emerging Markets performance was bolstered by improving inflation outlooks and anticipated rate cuts by central banks. The portfolio ended the quarter with a duration of 5.1 and a yield of 10.6%.
The Contrarian Opportunity portfolio rose over 6% during the quarter. Top contributors to performance included dominant franchise mega-cap technology/internet names that continued to rebound from last year’s growth stock wipeout: Meta Platforms (+0.7% to performance), Alphabet (+ 0.7% to performance), and Amazon (+ 0.4% to performance). Semiconductor maker Broadcom was also a strong contributor (+ 0.5% to performance), benefiting from the general excitement around artificial intelligence that lifted the sector broadly. The collective position in oil services company McDermott International, comprising multiple securities, was the only material detractor (-0.7% to performance) of more than 30bps.
Activity was relatively light during the quarter, with no material increases, decreases, or sales of existing positions. There were a handful of new positions added, including financial software company NCR Corp. and a fixed income position in Charles Schwab. The portfolio largely retains its general “barbell” of high-quality, dominant franchise positions at reasonable valuations, largely in the tech and communications spaces, balanced with cheap but more cyclical value stocks like financials and industrials, in addition to the healthy cash balance (26%), a “call option” on the ability to add risk exposure at significantly cheaper valuations if markets reprice downwards. Gross and net long exposure to equities is 63.8%. The largest sector concentration is in communication services, with financials and industrials following. These three sectors comprise approximately 56% of the equity portfolio. Meanwhile, credit exposure continues to methodically increase, ending the quarter at 6.5%. FPA has historically added to credit exposure significantly during periods of market stress, and is waiting for the opportunity to do that when corporate spreads widen out again.
The Absolute Return strategy was slightly positive in the second quarter. Securitized markets offered mixed results, generally outperforming US Treasuries, but lagging corporate issues. Commercial asset-backed securities (ABS) and collateralized loan obligations (CLOs) provided the strongest margin of outperformance, while consumer ABS were helped by the continued strength of the US consumer. After a quarter of underperformance, commercial mortgage-backed securities (CMBS) benefitted from reduced fears about the potential spillover effect of banking stress. Allocations to CLO and CMBS issues were primarily responsible for the sector’s positive impact on quarterly performance, with ABS and non-Agency RMBS holdings also contributing.
During the second quarter, equities were resilient and continued their positive momentum despite tighter financial conditions and softening nominal growth. Within equities, capital goods, energy, and technology names had the largest positive impact on performance.
Emerging markets assets were broadly aided by improving risk appetites and substantial contribution from yield. Additional tailwinds were provided by a stable US dollar and strong economic data in key markets such as India and Brazil. However, emerging markets assets detracted from performance in the portfolio due primarily to Chinese positions. The portfolio ended the quarter with a duration of 3.2 and a yield of 7.9%.
The Water Island Arbitrage and Event-Driven was very slightly positive in the quarter.
The top contributor in the portfolio for Q2 was a position in the bidding war for Circor International. In June 2023, Circor – a designer and manufacturer of highly engineered, mission-critical flow control products and systems for industries such as aerospace, defense, and energy – agreed to be acquired by investment firm KKR for $49 per share in cash, or approximately $1.5 billion total deal value. Arcline Investment Management, a private equity firm, subsequently emerged with a competing $57 cash bid worth approximately $1.7 billion in total, which is potentially worth $59 per share when considering termination fees to which Circor has the right, should its deal with KKR not proceed. KKR then bumped its bid to $51 per share, which remains Circor’s preferred offer – primarily due to what Circor views as a clearer path to receiving antitrust approvals and due to Arcline’s bid, unlike KKR’s, being contingent upon receiving financing. Water Island is maintaining the exposure and monitoring the situation closely, believing there may be more left to the story. Other top contributors for the period included positions in the acquisition of Silicon Motion Technology by MaxLinear and in Kaleyra convertible bonds. Over the quarter, the spread on the Silicon Motion deal narrowed based on positive checks regarding its progress in receiving antitrust approval in China, after having reportedly received pushback earlier in the regulatory review process. Kaleyra reached an agreement to be acquired by Tata Communications in June, which pushed its bond prices significantly higher.
Conversely, the top detractor for the quarter was a position in the failed acquisition of First Horizon Corp by Toronto-Dominion Bank (“TD”). In February 2022, First Horizon – a regional bank based in Tennessee that operates throughout the Southeast US – agreed to be acquired by TD – a Canada-based multinational banking and financial services corporation – for $13.4 billion in cash. While First Horizon was not directly connected to Silicon Valley Bank, the company’s shares were a casualty of indiscriminate selling across the US regional banking industry following the news of Silicon Valley Bank’s failure. This, combined with an extended regulatory review in Canada as well as rumors of a potential price cut, pressured the deal’s spread. Through the volatility, Water Island opted to maintain exposure to the transaction, as mere weeks prior TD had publicly reaffirmed its commitment to the transaction, and due to First Horizon’s relatively small size, the deal would have been one of very few paths for TD to gain scale via acquisition. As the regional banking crisis continued to unfold, leading to the additional failures of Signature Bank and First Republic, volatility in First Horizon shares escalated. Eventually, in May, when no progress had been made on the antitrust review front, First Horizon and TD mutually agreed to terminate the merger due to “uncertainty” as to when the deal might gain the lagging regulatory approvals. Other top detractors included positions in Broadcom’s acquisition of VMware and in the acquisition of PNM Resources by Avangrid. Both deals experienced spread volatility during the quarter due to tenuous regulatory approval processes, though Avangrid recently reaffirmed its commitment to its pursuit of PNM by agreeing to extend the deal timeline, and as of this writing in early July, Broadcom has reached an agreement with European regulators on certain behavioral remedies that appear to set the deal on a path toward approval.
Water Island Market Commentary
In recent months, the landscape for event-driven investing – in particular the merger arbitrage strategy – has been challenged by significant regulatory headwinds. Antitrust regulators around the globe have attempted to block several large mergers and acquisitions (“M&A”) transactions, in turn driving correlated volatility in deal spreads throughout the investment universe. At times, we have found the logic behind the regulators’ recent cases to be perplexing – particularly in the US, where the Department of Justice (“DOJ”) and the Federal Trade Commission (“FTC”), in our opinion, have sought to block deals based on novel legal theories with little basis in historical precedent or antitrust law.
While the FTC and DOJ have succeeded in causing some companies to abandon their planned tie-ups rather than pursue costly litigation, and their actions may have had a chilling effect on future M&A in certain sensitive industries or by large acquirers, the regulatory pendulum may be starting to swing back to the other side. At this point, of the cases that have gone to trial, the FTC and DOJ under the Biden administration have lost more than they have won. The most recent example is the FTC’s attempt to block Microsoft’s acquisition of Activision. At the end of June, based on our view of the trial’s proceedings and the skeptical tone of the presiding judge’s questions to the FTC, we believed it likely Microsoft would prevail; indeed, as of this writing in early July, the court has officially ruled against the FTC and reports are Microsoft could attempt to close the merger by July 17 (less than a week after the ruling). Based on the recent courtroom successes of corporate acquirers who have been willing to take their fight to the courts, we believe future acquirers may increasingly take a bolder stance against regulatory objections. Furthermore, within the ranks of agency staff, there has been considerable brain drain, which may be a result of skepticism regarding the current regime’s approach. In the past two years, for example, senior-level attorneys at the FTC have departed the agency at the fastest rate since 2000, which could make future enforcement actions more challenging.
While we are cognizant of the challenges that remain, amidst this environment, we believe the return opportunities in merger arbitrage are compelling. Volatility and rising interest rates are bolstering wider deal spreads, which have reached average levels we haven’t seen since the Global Financial Crisis. According to Dealogic data, the average gross day-one spread (i.e., the non-annualized spread the day after deal announcement) of pending deals as of June 30, 2023, was 9% – nearly double the rate on January 1, 2022, just 18 months prior. And while M&A deal flow has slowed somewhat, with deal volumes in 2023 declining from the already subdued levels of the second half of 2022, activity still remains above pre-pandemic 2019 levels, according to Refinitiv and PwC data – providing plentiful investment opportunities in M&A. Looking beyond merger arbitrage, given ongoing volatility in the broader markets, we continue to remain focused on hard catalyst investments, which should benefit from more definitive timelines and outcomes. In that vein, we are seeing attractive opportunities in merger-related credit and certain hard catalyst credit special situations, such as refinancings, and we anticipate the portfolio’s allocation to credit will grow in the coming months. We may introduce select soft catalyst investments – which typically have greater sensitivity to broader market moves – but only when we believe the potential reward outweighs the potential risk and when we can construct appropriate risk mitigation strategies.
The current allocations, reflecting the DoubleLine tactical overweight are 27% to DoubleLine, 17% each to DBi and Water Island, 15% to Loomis Sayles, 13% to Blackstone Credit Systematic Group, and 11% to FPA. (The Fund’s strategic targets are: 20% each to DBi and DoubleLine, 18% to Water Island, 15% each to Blackstone Credit Systematic Group and Loomis Sayles, and 12% 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, 2023
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top Five Sector Exposures|
|CDS Portfolio Statistics|
|Number of Issuers||70||71|
|Average Credit Duration||4.3||4.3|
|Spread||173 bps||164 bps|
|DBi Enhanced Trend Strategy|
|Asset Class Exposures (Notional)|
|DoubleLine Opportunistic Income Strategy|
|Agency Inverse Interest-Only||8.1%|
|Non-Agency Residential MBS||36.0%|
|Collateralized Loan Obligations||12.6%|
|FPA Contrarian Opportunity Strategy|
|Asset Class Exposures|
Loomis Sayles Absolute Return Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||6.4%||0.0%||6.4%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||87.9%||-10.5%||77.4%|
|Merger Arbitrage – Credit||3.2%||0.0%||3.2%|
|Special Situations – Equity||1.2%||0.0%||1.2%|
|Special Situations – Credit||2.2%||0.0%||2.2%|
|Total Special Situations||1.9%||0.0%||3.4%|