The iMGP Alternative Strategies Fund (Institutional Share Class) declined 3.09% in the first quarter of 2022. During the same period, the Morningstar Multi-strategy Category was down 1.18% and 3-month LIBOR returned 0.13%.
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.imgpfunds.com.
The Alternative Strategies Fund suffered one of its more challenging quarters in Q1, falling slightly more than 3%. While this result is obviously not pleasant, we also don’t believe it’s a terrible outcome in light of the broader circumstances facing financial markets (not to mention the “real” world). The fund held up better than the US equity market, as we would expect, with the S&P 500 down about 5% during the quarter, and about 13% at its trough, while the fund’s maximum drawdown was about 1/3 of that. Although performance was negative, the fund still held up much better than core bonds as well, outperforming the Bloomberg Aggregate Bond Index by close to three percentage points. (Subsequent to quarter end, that gap has widened to approximately five percentage points as core bonds have continued to sell off.)
We continue to like how the fund is positioned relative to the Agg going forward, with a higher yield and shorter duration. As of quarter end, our long-biased credit subadvisors’ (DoubleLine and Loomis Sayles) portfolios averaged a yield of over 6% with a duration of about 3. Additionally, Water Island’s merger arbitrage portfolio is showing an average annualized deal spread of over 8%. This is significantly higher than the levels seen most of last year, as risk has repriced higher across the investment landscape, in addition to the anticipation of higher short term risk-free rates. Meanwhile deal activity is still healthy by historical context, which is another tailwind for the strategy. The Blackstone Credit Systematic Group’s (fka DCI) long-short credit strategy also seems to be gaining traction as the macro environment is beginning to drive differentiation in credit spreads that more closely reflects the differences in fundamental health and future prospects of the underlying businesses. While the strategy’s defensiveness has been beneficial during challenging market periods, we look forward to seeing solid absolute performance contributions from their sleeve once again if the fundamental differentiation story continues to play out.
We, like many others, wondered previously about the Fed’s ability to “thread the needle” by taming inflation without tipping the economy into recession. That was before the Russian invasion of Ukraine threw fuel on the inflationary fire and made the situation even more challenging, prompting very hawkish sentiment from various Fed officials. We believe this effectively lowered the strike price of the “Fed put option” while consumer confidence and the likely growth rate of the economy is falling. Still, stocks rallied sharply late in the quarter before falling again in April as sentiment continues to shift rapidly.
We feel fortunate to have skilled and experienced subadvisors to navigate the fund through an extremely difficult environment. While they don’t get everything right, they have over time done well in managing prudently through market drawdowns and taking advantage of the resulting opportunities to generate future performance. Historically, the fund’s noticeable drawdowns have been followed by periods of strong performance. We have seen this pattern repeatedly, and we expect it to continue. With that said, we continue to evaluate several strategies that we believe may be additive to the fund’s risk-adjusted returns due to their complementarity to the existing subadvisors. We will of course provide more detailed updates on this when relevant.
iMGP Alternative Strategies Fund Risk/Return Statistics 3/31/2022
|Statistics of 3/31/2022||MASFX||Bloomberg US Agg Bond Index||Morningstar US Fund Multistrategy||HFRX Global Hedge Fund Index||Russell 1000 Index|
|Annualized Return 2011-10-01 to 2022-03-31||4.4||2.3||3.1||2.3||16.4|
|Cumulative Return 2011-10-01 to 2022-03-31||56.9||26.6||37.4||26.6||390.5|
|Std Dev 2011-10-01 to 2022-03-31||4.6||3.2||4.2||4.2||13.6|
|Sharpe Ratio 2011-10-01 to 2022-03-31||0.8||0.5||0.6||0.4||1.1|
|Beta to Russell 1000 2011-10-01||0.3||0.0||0.3||0.3||1.0|
|Correlation of MASFX to 2011-10-01 to 2022-03-31||1.0||0.2||0.9||0.9||0.8|
|Worst 12-Month Return||-5.4||-4.2||-5.7||-8.2||-8.0|
|% Positive 12-Month Periods||85.2%||72.2%||79.1%||73.0%||94.8%|
|Up Capture Ratio vs Russell 1000 2011-10-01 to 2022-03-31||27.3||6.7||25.4||22.1||100.0|
|Down Capture Ratio vs Russell 1000 2011-10-01 to 2022-03-31||27.1||-4.0||33.6||32.8||100.0|
|Up Capture Ratio vs Agg 2011-10-01 to 2022-03-31||84.9||100.0||69.7||48.9||241.8|
|Down Capture Ratio vs Agg 2011-10-01 to 2022-03-31||8.7||100.0||23.0||12.3||-71.8|
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, four sub-advisors produced negative returns. The Blackstone Credit Systematic Group’s Long-Short Credit strategy lost 1.02%, FPA’s Contrarian Opportunity strategy declined 3.20%, DoubleLine’s Opportunistic Income strategy fell 4.78%, and the Loomis Sayles Absolute Return strategy was down 5.03%. Only the Water Island Arbitrage and Event-Driven produced a modest positive return, gaining 0.15%. (All returns are net of the management fee charged to the fund.)
Key performance drivers and positioning by strategy
Blackstone Credit Systematic Group (DCI):
The Long-Short Systematic Credit portfolio returned approximately -1.0% in the quarter. The portfolio has lagged on a weak alpha start to the year, but in an encouraging sign, that dynamic largely reversed itself in March. The bond portfolio is well-hedged out the rate curve but retains some exposure to front end yields. This net duration has been close to ½ year, which accounts for almost -0.9% performance amidst the huge jump in expectations for the Fed Funds moves this year.
Market moves have been dramatic so far this year, with bond returns coming under pressure from both higher rates and wider spreads. While the Russia invasion spiked risk, much of the initial risk aversion fears eventually calmed. U.S. equities rallied in March and the VIX index dropped nine points to finish the month at 21. The news from Europe remains grim, however, and equities in Europe are down notably for the quarter. Commodity prices have rallied and WTI closed the month at about $100. However, credit market moves were driven by the Fed, as they increased the Funds rate to initiate a tightening cycle and guided market expectations higher to now price in 7 additional hikes this year. The U.S. two-year Treasury closed March with a yield of 2.33%, rising by over 150 bps since the start of the year.
Despite spreads being wider for the period, the contribution of credit beta to the portfolio for Q1 was about flat and the hedging performed in line with expectations. However, credit alpha in the bond sleeve was negative over the quarter. Positions in energy names were a notable positive contributor, but positions in consumer durables including autos and household goods were a more-than-offsetting negative. Technology also contributed negatively. The model’s portfolio views have not changed much over the quarter, and DCI expects some of these moves to revert. The portfolio continues to show balanced positioning across recovery names, which remains comforting amidst uncertainty around the new economic reopening. Energy continues to be attractive, despite the market rally, because the sector recovery has gained traction and the longer-term prospects – particularly so given higher oil prices – look positive relative to spread levels. The portfolio risk, by design, is spread out across various idiosyncratic names. The bottom-up sector tilts are modest relative to the overall portfolio risk, and the portfolio continues to be unusually neutral in most sectors. It is long in energy and newly flat in consumer goods (favoring some select retail and consumer brands). It is also broadly neutral (a bit underweight) in financials, and remains long in technology (especially consumer-facing and networking) and short in telecoms. The portfolio had no Russia exposure.
The credit derivative overlay delivered a huge turnaround since mid-February, helping to lift the overall alpha in the portfolio. Positive returns from a number of short positions in retail, travel, and homebuilders contributed significantly, leading broad-based strong alpha. This is a very promising sign, as that strategy has been struggling for much of the period following the initial pandemic shock, and looks set to continue into the remainder of 2022. When geopolitical risks and uncertainties recede, DCI expects the market environment to be supportive of future convergence in credit selection. Dispersion in fundamentals and default probabilities are both elevated and varied, leading DCI to anticipate positive alpha in the portfolio as credit fundamentals take over during the differentiated economic seasoning phase of the recovery.
For the quarter the DoubleLine Opportunistic Income portfolio was down 4.8%, but outperformed the Bloomberg US Aggregate Bond Index 5.9% loss. The outperformance was primarily driven by duration positioning as the portfolio consistently maintained a lower duration than the index and rates rose sharply during the quarter. Specifically, the 2-year and 10-year portions of the US Treasury curve rose by 160bps and 83bps, respectively, as the Federal Reserve enacted more hawkish policy guidance to combat inflation. The severity of the rate move caused negative returns for all major fixed income asset classes and even some floating rate assets with longer coupon reset periods. The worst-performing sector in the portfolio was naturally Agency MBS and US Treasury exposures, which are the longest duration assets in the portfolio. The most prominent credit sectors, such as non-Agency RMBS and non-Agency CMBS, sharply outperformed the index but still generated negative returns. CLOs were the top-performing sector in the portfolio due to floating rate coupons that are indexed to the front end of the yield curve. The portfolio ended the quarter with a duration of 3.9 and a yield of 8.0%.
The Contrarian Opportunity portfolio lost about 3.2% during the quarter. The top contributors for the quarter were relatively minor, with Glencore (+0.6%) the only position adding more than 50bps, benefitting from the continued huge bull run in commodities. AIG (+0.3%), Activision Blizzard (+0.3%), McDermott International (+0.2%), and Aon (+0.2%) were the other significant contributors. Not surprisingly, the largest detractors for the quarter were mainly high growth/tech names like Meta Platforms (-0.9%), Naspers & Prosus (-0.8%), and TE Connectivity (-0.5%). Charter Communications (-0.4%) and Jefferies Financial (-0.3%) also hurt performance.
Investment activity continued to focus on the consumer/technology space, adding to existing positions in Netflix, Amazon and Open Text, and initiating a position in Delivery Hero. The PMs believe they are buying high-growth, long-term winners at steep discounts to recent prices (even if some of those prices were overly optimistic in some cases) due to the negative macro environment. They believe these quality businesses should be able to grow in-line with or better than inflation. The PMs also reduced the portfolio’s market hedge during the quarter.
Exposures remained quite consistent from a quarter ago, at about 72%, net long equity, 1% credit and 26% cash. The largest sector concentration is still in Communication Services, with Financials and Information Technology next, collectively accounting for over 60% of the equity exposure. About one-third of the equity portfolio is in foreign stocks, as the portfolio managers continue to find attractive opportunities outside the US. Although there has been some marginal buying, significant dry powder (26% cash) remains to take advantage of potential further dislocations stemming from the myriad economic and geopolitical risks currently present in markets.
The Absolute Return strategy had a difficult quarter, declining by 5.0%. High yield corporate bond spreads meaningfully widened during the quarter despite outperforming investment grade corporate issues due to a generally lower degree of interest rate sensitivity. Within the portfolio, communications and consumer cyclical issues detracted the most. Emerging market assets faced headwinds caused by a stronger US dollar, a softer global growth outlook, and the disproportionate impact of Russian military action in Ukraine. The portfolio’s emerging markets positions detracted from performance overall, with Chinese and Mexican exposures most responsible for losses.
Investment grade corporate issues underperformed Treasurys as increased risk aversion caused yield spreads versus government issues to rise. Longer-duration issues bore the largest impact of the downturn, while higher-quality issues lagged lower-rated bonds within the investment grade market. Investment grade corporates weighed on the portfolio’s performance, with financial and consumer cyclical names being responsible for the largest share of the losses. However, global rates tools (primarily sovereign bonds and interest rate futures) contributed positively to performance. The yields of the benchmark 10-year and 30-year US treasury experienced significant volatility during the quarter because of persistent elevated inflation and the Fed pivot, with yields ranging from 1.63%-2.48% and 2.01%-2.60%, respectively. The portfolio’s short exposure to US treasury futures was responsible for the majority of the positive performance. The portfolio’s calculated duration is 2.4, with a yield of 4.0%.
The Water Island Arbitrage and Event-Driven portfolio generated a small gain (+0.2%) in the quarter. Merger arbitrage generated a gross positive return of about 0.6% while special situations lost about 0.3%.
The top contributor in the portfolio for Q1 was a position in the merger of Xilinx and Advanced Micro Devices. In October 2020, Xilinx – a US-based semiconductor manufacturer – agreed to be acquired by local peer Advanced Micro Devices for $35.7 billion in stock. This transaction experienced ongoing volatility in the deal spread, in large part due to its lengthy timeline stemming from continued delays in receiving regulatory approval from China (a required condition to complete the deal, where antitrust reviews are a notoriously opaque process). The companies ultimately received approval from China in February 2022 and the merger subsequently closed successfully, leading to gains for the fund. Other top contributors included the planned acquisition of drugmaker Swedish Orphan Biovitrum by private equity firm Advent International and the acquisition of medical software provider Change Healthcare by UnitedHealth Group, the largest health insurer in the US. While the Swedish Orphan deal was terminated after it failed to meet the required acceptance threshold due to opposition from a large shareholder, the company’s shares nonetheless rallied during Q1 due to improving fundamentals and the likelihood of another suitor emerging, leading to gains for the fund. And despite the DOJ suing to block the Change Healthcare deal from proceeding based on antitrust concerns, the company’s shares also rallied during the quarter based on improving fundamentals and UnitedHealth’s clear commitment to the deal – the companies revised the merger agreement to extend the termination date (for a second time) to allow time to fight the DOJ in court, at the same time adding a bump in the deal value (via a $2/share special dividend due at closing) and implementing a hefty termination fee for Change Healthcare should the transaction fail.
The top detractor in the portfolio for Q1 was the position in insurance giant Willis Towers Watson. Following the failure of the company’s merger with Aon due to regulatory concerns, Water Island maintained exposure rather than exit in the midst of widespread selling, which had put pressure on the share price. Instead, they opted to take advantage of the volatility by trading around the position, and in the aftermath of the deal break, multiple activist investors have initiated positions in Willis Towers and gained board seats. The portfolio managers continue to unwind exposure on strength as the activists seek to implement constructive changes at the company or even push for another sale. Other top detractors included a position in the planned merger of software companies Momentive Global and Zendesk, which failed after Zendesk shareholders voted down the deal (believing instead Zendesk itself should be sold), and a special situations position in MoneyLion, a fintech company brought public through a special purpose acquisition company that has experienced share price volatility alongside broader equity and cryptocurrency markets and selling pressure from insiders as their lockups expire.
Water Island Market Commentary
The first quarter of 2022 was one of the most challenging periods in recent history for market participants. Volatility ruled the day, with no shortage of sources – whether new variants of COVID-19, supply chain dislocations, runaway inflation in the US, fears of interest rate hikes from the Federal Reserve (“Fed”), or Russia’s unlawful and unprovoked invasion of Ukraine. US Treasury rates more than doubled during Q1, leading to losses in investment grade bonds of a scale not seen since the Taper Tantrum of 2013. Rates for two-year Treasuries also briefly rose above those for ten-year Treasuries, causing an inversion of the yield curve – a phenomenon that has preceded six of the past seven recessions. Global equities did not escape unscathed, as higher rates impacted valuations. With a need to curb inflation by raising short-term rates and reducing its balance sheet, there does not appear to be an easy solution for the Fed, as these actions could have unintended consequences by negatively impacting consumer behavior and economic growth, especially if the Fed raises rates too much, too quickly.
For our event-driven strategies, the quarter was similarly fraught. In this environment, we remained focused on short duration, hard catalyst events (particularly merger arbitrage opportunities) and implementing strict hedges. While the future remains bright for merger arbitrage, we expect stumbling blocks along the way. As we have often mentioned, the three pillars of merger arbitrage returns are interest rates, volatility, and deal flow. Rising rates have historically been a boon for the strategy, and we would welcome prudent Fed action in that arena as it should lead to more attractive spread levels in newly announced deals. During Q1, we saw forced selling drive certain share prices to levels beyond our expectations for valuation even in a recession. While the ups and downs of such dramatic market volatility can instill some with unease, for those that are able to avoid becoming forced or panicked sellers, we believe it presents attractive entry points for opportunistic trading. The pace of newly announced mergers and acquisitions (“M&A”) in Q1 followed a similarly unpredictable trajectory as the direction of broader markets. January began the year slow, which is not entirely uncommon, only for February to provide one of the most fertile months for arbitrage opportunities we have seen in recent memory. After the Russia/Ukraine conflict erupted late in the month, deal flow began to slow down in the first half of March as M&A participants pulled planned announcements amidst geopolitical uncertainty. Yet the pause did not last long, as M&A announcements came roaring back in the latter half of March. Overall, if you read the headlines, yes – Q1 deal flow is down…compared to the record-setting all-time highs we experienced over the past couple years. Yet the level of activity remains robust (similar to levels seen from 2016-2019), with more than $1 trillion worth of transactions announced through the first three months of the year.
Looking ahead, we expect healthy deal flow to persist through the remainder of the year. By some accounts, the uncertainty in the broader environment may actually be spurring further activity, as companies look to bolster their competitive position. A theme certainly emerged during Q1, where we saw a large percentage of announced M&A predicated on helping the acquirer resolve one of two issues: supply chain woes or worker shortages. In this environment of dislocated valuations, we expect cash to reign supreme as the consideration of choice. With ongoing geopolitical concerns, volatility, and macroeconomic uncertainty, companies should be less likely to try to use the full weight of their market capitalization to effect an all-stock acquisition. As such, we might see fewer mega deals and more mid-cap deals in the $2-10 billion range. This happens to be a sweet spot for private equity (“PE”) buyers, who we anticipate will continue to comprise a larger segment of announced M&A, as PE shops can often skirt regulatory objections or delays (as they typically do not have the same antitrust concerns as strategic acquirers) and they still hold record levels of dry powder on their books, even though they already deployed enough cash in 2021 to set an all-time high for PE acquisition activity.
Under the Biden administration, the regulatory environment in the US remains an area of focus for us. Over the past year, we have experienced multiple deal breaks in the portfolio, several of which encountered objections from the Federal Trade Commission (“FTC”), Department of Justice (“DOJ”), or Committee on Foreign Investment in the United States (“CFIUS”) based on antitrust or national security concerns. We have also seen transactions scuttled due to shareholder objections. While the level of breaks in the portfolio is unusually high – approaching what we experienced in the 2004-2005 timeframe, which is one of the most unusual periods we have ever seen for merger arbitrage – this time the outcomes are different. In several circumstances, we have seen target shares respond favorably in the weeks or months following the break, whether due to improved fundamentals in the time since initial announcement or to the potential for other suitors to emerge, based on the presence of an activist investor or background bidders noted in the broken deal’s merger proxy. This has presented opportunities to mitigate the impact of failed deals, and at times we may opt to maintain exposure in such scenarios in order to unwind our positions in an orderly fashion – though we have a strict set of criteria that must be met to do so, including the presence of a near-term catalyst.
We expect markets to remain challenging over the next several quarters. Inflation needs to be controlled and the natural solution is for the Fed to aggressively raise rates. The path forward will be more about the speed at which rates rise and how this impacts market and consumer psychology. Significant tail risks also remain, particularly with respect to escalation in Ukraine. Should Russia retaliate against Western sanctions by cutting oil and gas to Europe, this could jeopardize European economies and heighten the risk of recession there. In such an environment our best path as managers is to maintain our focus on hard catalysts investments with short durations, while implementing stringent risk management procedures and ensuring our positions are adequately hedged. Despite the uncertainty ahead, we are optimistic about the prospects for our strategy.
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 March 31, 2022
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top Five Sector Exposures|
|CDS Portfolio Statistics|
|Number of Issuers||68||58|
|Average Credit Duration||4.8||4.8|
|Spread||150 bps||165 bps|
|DoubleLine Opportunistic Income Strategy|
|Agency Inverse Interest-Only||8.2%|
|Collateralized Loan Obligations||9.4%|
|Non-Agency Residential MBS||32.4%|
|FPA Contrarian Opportunity Strategy|
|Asset Class Exposures|
Loomis Sayles Absolute Return Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||7.3%||0.0%||7.3%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||101.9%||-4.5%||97.4%|
|Merger Arbitrage – Credit||3.0%||0.0%||3.0%|
|Special Situations – Equity||1.0%||0.0%||1.0%|
|Special Situations – Credit||2.8%||-0.1%||2.7%|
|Total Special Situations||3.8%||-0.1%||3.7%|