The iMGP Alternative Strategies Fund (Institutional Share Class) gained 0.63% in the first quarter of 2023. During the same period, the Morningstar Multistrategy Category was up 1.07%, the ICE BofA 3-Month Treasury Bill Index was also up 1.07%, and the Bloomberg US Aggregate Bond Index (the Agg) was up 2.96%.
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.
Quarterly Review
The Alternative Strategies Fund continued to gain ground, albeit more slowly than we would like, rising again in the first quarter of the year. Five of the six subadvisors were positive during the quarter, with only DBi detracting from returns due to the extremely negative environment for trend following, which makes up the majority of the strategy DBi manages for the fund. (In the category of small silver linings, the equity hedge component of the DBi strategy added value and moderated losses from trend, as we expected when we designed the strategy with DBi.) The Silicon Valley Bank (SVB) failure caused a sharp drop in yields across the curve, but particularly in the short end, where it produced a double-digit-standard-deviation move, something that (if returns were normally distributed) should never happen in one’s investment career. Not surprisingly, March was a very rough month for the managed futures industry, trend followers in particular, almost all of which were still short rates/bonds to varying degrees and got clobbered by the move. Ironically, the same losses on bonds that trend followers rode to huge gains in 2022 ultimately triggered the run on the bank at SVB when depositors noticed the giant losses in SVB’s investment portfolio and started pulling their uninsured deposits en masse. While the beginning of DBi’s inclusion in the fund has been less than ideal, it doesn’t diminish our expectation of the strategy adding significant value to the fund over the medium and long term.
Turning to the positive, the fund’s tactical overweight of DoubleLine, implemented in early January, has added value so far, as they were the second-best performing subadvisor during the quarter (+3.7% net of management fee). The portfolio DoubleLine manages for the fund had a yield to maturity (YTM) of over 11% when we decided to make the change, and despite the gains this quarter, the portfolio is still very attractive, with a YTM over 10% at the end of the first quarter. As a reminder, we added seven percentage points to DoubleLine’s allocation, taking it to 27% of the fund’s portfolio, reducing four of the other subadvisors by between one and three percentage points each. The Loomis Sayles allocation remained unchanged since it also had a very positive risk-adjusted return profile in our view, though not the same potential 12- to 18-month upside as DoubleLine, all else equal. Together, the long-biased fixed income managers weighted average YTM was almost 9.5% with a duration of 4.2 at quarter end, a strong tailwind for future performance.
Additionally, Water Island’s merger book showed a weighted average annualized deal spread of over 20%. It’s highly unlikely that the portfolio will produce returns of that magnitude over a 12-month period for numerous reasons, including the likelihood of at least a couple of deal extensions or breaks, but the annualized spread has very rarely been this attractive. Water Island, Loomis Sayles, and DoubleLine in combination make up almost 60% of the portfolio. Including deal completions in the merger arb portfolio, as well as income and “pull-to-par” in the fixed income portfolios, these sleeves of the fund are what we’d consider “harder-catalyst” strategies. In general, they should realize value more quickly than catalyst-free strategies (e.g., long-only equities) that essentially rely on the market ultimately agreeing with an investor’s thesis to drive excess returns. It should go without saying that we still really like the other portfolios as well, and they all play an important role in the fund. However, we’re very enthusiastic about the fund’s prospects going forward given how much of the fund is allocated to these high-yielding, harder-catalyst strategies, combined with their high return potential.
iMGP Alternative Strategies Fund Risk/Return Statistics 3/31/2023
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, five of six sub-advisors produced positive returns. FPA’s Contrarian Opportunity strategy gained 4.35%, DoubleLine’s Opportunistic Income strategy returned 3.66%, the Blackstone Credit Systematic Group’s Long-Short Credit strategy was up 2.01%, the Loomis Sayles Absolute Return strategy increased by 1.61%, and Water Island’s Arbitrage and Event-Driven strategy gained 0.46%. Only DBi’s Enhanced Trend strategy was a detractor, falling by 6.11%. (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 2.0% in the quarter and was notably positive in the month of March with a return of +0.8% (net) even amidst the sharp decline in credit during the month and the collapse in banking names. Alpha performance was strong for the quarter, driven by the long side of the portfolio against a backdrop of idiosyncratic credit improvement. 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 and long energy names provided the largest performance contribution, as well as security selection within transports and travel. Telecom and durables were negative contributors, as well as longs in healthcare and shorts in pharma and utilities.
The portfolio was well hedged over the period and so the macro footprint was limited. This was nice to see given the market gyrations and huge moves in sentiment and in rates. The MOVE Index of interest rate volatility hit a new post-GFC high over the quarter as the market began to aggressively price the end to the Fed’s tightening cycle. But 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 has played out in both the corporate bond and CDS sleeves. Both sleeves made notable contributions to performance for the quarter. DCI expects this positive alpha environment to continue, with the market environment supportive of future convergence in credit selection, with dispersion in fundamentals and default probabilities both elevated and varied. The portfolio managers anticipate that the positive alpha loadings in the portfolio should pan out as the market moves through this economic inflection point.
DBi:
The sudden emergence of a global banking crisis caused a violent reversal in the fixed income markets — market commentators called it a “13 standard deviation move” in the short end of the yield curve. The crisis was compounded as Credit Suisse succumbed to the contagion and had to be rescued by UBS via a weekend deal. Inflation concerns were temporarily pushed aside, and all hands were on deck to shore up public trust in the global banking system. Shortly after the squall, and to preserve their inflation fighting credibility, central bankers around the globe raised rates by token amounts and signaled that the end to rate hikes could be near. As with other inflection points, we expect material shifts in the portfolio over coming weeks as managers jettison losing positions and hunt for new opportunities. This is a big shift on the macro front. Throughout the tightening cycle, we could all take comfort that the banking system – the essential plumbing of the markets– was functioning smoothly; that is no longer a given. A month ago, the Fed cutting rates was associated with a victory dance on inflation and refilling the punch bowl; today it looks more like triage and a blood infusion.
The Enhanced Trend portfolio declined approximately 6% during the first quarter of 2023. The sudden banking crisis caused significant uncertainty which led investors into safe haven investments, especially treasuries. Due to this, the short interest rate positions, as well as a short in the Japanese Yen versus the U.S. Dollar, detracted from performance. The Euro was also impacted by the Credit Suisse failure which led to a volatile quarter. However, a well-timed increase in exposure towards the end of February led to gains for the quarter. Commodity swings whipsawed positioning in crude oil and gold due to market participants torn between a hard or soft landing from the rate hikes. Equity asset classes were highly correlated during the quarter. A large rally in January due to hints about the end of the hiking cycle was reversed in February. As contagion fears abated, the rally picked up in March. The volatility caused swings in positioning which further contributed to losses. The portfolio is more balanced today as the short positions in rates have been reduced.
DoubleLine:
For the quarter the DoubleLine Opportunistic Income portfolio’s 3.7% gain beat the Agg. This was another eventful period in the markets as inflation remained relatively high and the Federal Reserve’s monetary policy stance remained hawkish. Three prominent bank failures during March threatened to unhinge the Fed’s commitment to tightening policy, but the committee largely stood their ground and the quarter ended with the Federal Funds target range at 4.75% to 5.00%.
Intermediate and long-term US Treasury rates rallied during the quarter, however, as the forward-looking pricing function for interest rates began to anticipate looser monetary policy in the latter portions of 2023 and beyond. As a result, the top-performing sectors in the portfolio were Agency MBS and US Treasury exposures. These assets rallied sharply due to their specific yield curve sensitivities and outperformed their index counterparts. Another standout sector was domestic high yield bonds, which enjoyed some spread tightening due to the market-based expectations of lower short term rates in the future. The only sectors that generated negative quarterly returns were ABS and non-Agency CMBS. The ABS sector suffered from some weakness in junior aviation debt and consumer loans. The non-Agency CMBS sector experienced a small, negative quarterly return as headline risk generally drove spreads wider for this asset class.
FPA:
The Contrarian Opportunity portfolio was up over 4% during the quarter. The top contributors for the quarter were a mix of dominant tech/internet names that rebounded in Q1 — particularly Meta Platforms (contributed 0.8% to the portfolio’s total return), which was up over 75% during the quarter after management indicated an intention to focus on efficiency and financial discipline, highlighting the potential for dramatically higher margins – and more traditional value stocks like Holcim (0. 7% contribution to total return) and McDermott International (0.3%). In a quarter featuring a banking crisis and spotlight on losses in bond portfolios, the largest detractors not surprisingly included financials American International Group, Inc. (detracted 0.5% from total return) and Wells Fargo & Company (-0.2%). Apart from the run-off of some of the SPAC book, investment activity was relatively light during the quarter in terms of new additions or liquidations. With that said, the portfolio managers did initiate some interesting new positions, including a small cap energy-related investment company. They also began to opportunistically dip into the troubled commercial real estate market by initiating small debt and equity positions in a very limited number of public REITs.
Exposures are similar to where they were at year end, although a bit more conservative, with equity exposure down over five percentage points to roughly 60%, bonds slightly higher at almost 6%, and cash about four percentage points higher at 31%. The largest sector concentration is still in Communication Services, with Financials still second, and Industrials climbing into third place, just ahead of IT. The top three sectors collectively account for almost 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 have been some new names added, the proceeds from trims and sales during the Q1 rally have largely gone to add to the significant dry powder (31% cash) in the portfolio available to take advantage of potential declines in either equity or credit markets.
Loomis Sayles:
The Absolute Return strategy had a positive quarter, gaining 1.6%. Investment grade corporate bond spreads generally rose relative to government bonds, however the sector’s higher average yield was more than enough to offset this factor. For the portfolio, investment grade corporates contributed to performance with financial and technology names being primarily responsible. US high yield corporate bond spreads tightened to end the quarter despite first widening around the initial news of turmoil in the banking sector. The category was broadly helped by an absolute yield advantage relative to other segments of the market, and the portfolio’s allocation to the sector contributed positively to performance. Consumer names were mostly responsible for the positive impact.
Securitized markets generally showed strength during the quarter. The outlier however was the CMBS sector, which saw negative total and excess returns. Broader concerns about commercial real estate rose due to banking sector stress and increased likelihood of loan extensions and strategic defaults. The allocation to ABS issues was primarily responsible for the sector’s positive impact on quarterly performance, with non-Agency RMBS and CLO holdings also contributing.
Water Island:
The Water Island Arbitrage and Event-Driven portfolio generated a small gain of about half a percent in the quarter.
Deal Highlights
The top contributor in the portfolio for Q1 was a position in the acquisition of Activision Blizzard by Microsoft. In January 2022, Microsoft reached an agreement to acquire Activision Blizzard, a US-based developer and publisher of video game software, for $75.1 billion in cash. The deal was met not just with objections from competitors, including Sony, but also wariness amongst antitrust regulators, which has caused ongoing volatility in the deal spread. During Q1 2023, however, the UK CMA signaled a more favorable assessment of certain aspects of the transaction (namely the continued availability of certain top tier franchises, such as Call of Duty, on competing gaming platforms), leaving the future market for cloud gaming as the final scope of its review. The positive news led to spread narrowing and gains for the fund. Water Island continues to believe this deal will ultimately achieve a successful close and maintains the exposure.
Other top contributors for the period included Rogers Corp and Momentive Global. Rogers was the target of an acquisition by DuPont de Nemours which was terminated in November 2022. News of the deal break caught many arbitrageurs by surprise and the company’s shares subsequently traded down to what we believed were significantly oversold levels. Rather than sell in the midst of the panic, the portfolio managers followed their deal break protocol and waited for more normalized trading levels, which arrived when Rogers shares traded nearly 37% higher over the course of Q1. Momentive was similarly the victim of a deal break, in this case after agreeing to be acquired by Zendesk following an activist investor agitating for a sale, only for a separate activist at Zendesk to push to reject the Momentive deal and put Zendesk up for sale instead. Water Island maintained the Momentive exposure based on the reemergence of the initial activist and were rewarded in March 2023 when the company agreed to be acquired by Symphony Technology Group for $1.5 billion in cash.
Conversely, the top detractor for the quarter was a position in the 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, have pressured the deal’s spread. TD publicly reaffirmed its commitment to the transaction in March and the outlook on the deal has not changed, though Water Island is monitoring this situation closely.
Other top detractors included positions in the acquisition of Tegna by Standard General and Broadcom’s acquisition of VMware. The Tegna deal spread traded wider after the Federal Communications Commission (FCC) designated the transaction for judicial review based on concerns it could raise prices for consumers. Such hearings are typically lengthy and have not historically led to favorable outcomes for M&A, and Standard General filed a lawsuit against the FCC in response, describing the FCC’s move as “an unprecedented and legally improper maneuver,” as it had not previously expressed any concerns with the transaction during its nearly year-long review. During Q1, VMware and Broadcom agreed to extend the deal’s timeline as the transaction is facing in-depth investigations from multiple global antitrust regulators, which has caused delays in receiving required regulatory clearances in several jurisdictions, including the US, UK, and EU. Reports also emerged claiming the US Federal Trade Commission (FTC) was interviewing third parties about the deal in preparation for a potential lawsuit to block the transaction.
Water Island Market Commentary
For many, the year began with a perception that the Federal Reserve (Fed) had successfully engineered a soft landing for the flagging economy and was done with further interest rate hikes. Sentiment began to change in February, however, as inflation proved stubborn, and the Fed communicated the possibility that rate hikes could continue. In this environment, the landscape for mergers and acquisitions (M&A) activity has been challenging. Concerns about the broader economy and the prospect of a potential recession in the US have made corporate executives hesitant to proceed with transactions in some sectors. As such, deal flow was already slow during Q1 when, in March, the collapse of Silicon Valley Bank in the US and the rescue of Credit Suisse via acquisition by UBS upended the market for dealmaking even further. The risk of contagion in the banking industry drove investors to safe harbor investments and acquirers put a pause on planned acquisitions, while the Fed was faced with the dilemma of curbing inflation with rate hikes or tempering any contagion with less aggressive moves. Ultimately, the Fed chose a conservative course during its March 22 meeting by raising rates 25 basis points – half the amount that had been expected prior to the banking tumult.
Amidst the broader volatility, many M&A transactions traded to wider spreads, as companies involved in deals experienced increased selling pressure along with the rest of the market. As is often the case during such turmoil, we found buying opportunities in high conviction positions and were able to put dry powder to work, which benefited the portfolio when spreads began to snap back by the end of March. More broadly, however, average deal spreads widened over the full duration of the quarter. Regulatory concerns fueled much of the ongoing spread volatility, as a heightened antitrust environment left several notable pending transactions in limbo (and may have further contributed to curtailed deal flow by eroding boardroom confidence that a desired transaction would receive clearance). That said, there were several positive developments on that front by quarter-end, including a shift on the part of the UK’s antitrust regulator – the Competition and Markets Authority – to a more favorable assessment of Microsoft’s bid to acquire Activision Blizzard; the receipt of regulatory clearance in two large acquisitions by CVS Health (for Oak Street Health and Signify Health) which had each been subject to extended antitrust reviews; the successful closure of Semtech’s acquisition of Sierra Wireless after having received a second request from the Department of Justice (DOJ); the uneventful clearance of Amazon’s bid for primary care provider One Medical; and the approval of the tie-up between Canadian telecommunications giants Rogers Communications and Shaw Communications, two years after announcement. As we have discussed in prior commentary, increased antitrust scrutiny of M&A – which as of late is often based on novel views of competition regulation – has increased volatility in the merger arbitrage strategy, but many of the deals being most closely investigated by regulators continue to reach a successful conclusion, reinforcing our view that established legal precedent in M&A law will continue to prevail.
The headwinds to deal flow are genuine. Dealmakers must face fading boardroom confidence, the potential for recession, an uncertain regulatory environment, and a more challenging market for financing. Regardless, consolidation activity, while slow, continues to occur – albeit sporadically. Robust deal flow may be preferable, but we note it is not a requirement of success in the merger arbitrage strategy. In more than 20 years we have never experienced a period when the level of deal activity did not exceed the amount of capital we had to put to work. Depressed equity valuations may serve as another obstacle, as they may make some takeout targets hesitant to negotiate deals for fear of selling too low. (Though they can be a double-edged sword, as they can also spur well capitalized acquirers to seek opportunities to take advantage of fallen prices and draw out activist investors who may agitate for a sale.) Despite these hurdles, there have been bright spots in sectors such as healthcare, technology, and industrials, which continue to make up a meaningful portion of consolidation activity. Furthermore, the global private equity (PE) industry continues to sit on a substantial amount of dry powder after having entered the year with nearly $2 trillion in cash available for acquisitions. While PE activity has remained healthy, it is nonetheless below the record-setting levels witnessed during the 2021-early 2022 timeframe, and the difficult market for debt financing has forced PE buyers to fund a greater portion of purchase prices through equity. Once the markets reopen in earnest, however, we believe the pressure will be on PE firms to negotiate deals and put their dry powder to work more swiftly, which could lead to a flurry of activity.
Looking ahead, we are cautious but optimistic. With regard to newly announced activity, we may see fewer large and mega deals given the ongoing regulatory landscape and current interest rate levels (which may impact buyers’ ability to finance larger acquisitions), but we anticipate more opportunities in mid-sized deals. Moreover, merger arbitrage spreads are trading at compelling rates of return – reaching levels we haven’t seen since 2008. Yet there are few opportunities in this environment that can be described as “plain vanilla.” We are wary of the potential for deals to fail not just for regulatory interference but also due to valuations. The rapid rise in interest rates has the potential to cause buyer’s remorse in transactions initially struck in a materially different rate environment. At the same time, a broken deal doesn’t always have to translate directly to portfolio losses. Despite spikes in volatility during Q1, over the course of the quarter markets generally traded higher. Alongside that rally, our assessments of valuations in the event of a potential deal break increased in many sectors – meaning potential downsides may have been mitigated, thus improving risk/reward ratios in several segments of the deal universe. For example, in the midst of this year’s rally in the technology sector, we have seen deal break valuations for targets in some tech deals reach levels above the agreed to deal price – which, in some scenarios, may even cause target shareholders to try to vote down a deal if they cannot negotiate a better price. During this exciting and interesting time, our process remains anchored in deep-dive fundamental analysis – understanding what we own and what it’s worth, so we can maintain a disciplined risk framework around the portfolio. Our goal, as always, is to seek to minimize drawdowns when events deteriorate, while delivering non-correlated returns sourced from the successful outcome of idiosyncratic corporate events rather than overall market direction.
Strategy Allocations
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 March 31, 2023
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
| Bond Portfolio Top Five Sector Exposures | |
| Consumer Discretionary | 18.4% |
| Energy | 14.6% |
| High Tech | 14.3% |
| Investment Vehicles/REITs | 8.6% |
| Consumer Non-Discretionary | 5.6% |
| CDS Portfolio Statistics | ||
| Long | Short | |
| Number of Issuers | 70 | 68 |
| Average Credit Duration | 4.5 | 4.6 |
| Spread | 200 bps | 188 bps |
| DBi Enhanced Trend Strategy | |
| Asset Class Exposures (Notional) | |
| Rates | -76.3% |
| Currencies | -1.6% |
| Commodities | -3.4% |
| Equities | 13.2% |
| DoubleLine Opportunistic Income Strategy | |
| Sector Exposures | |
| Cash | 2.4% |
| Government | 12.4% |
| Agency Inverse Interest-Only | 8.6% |
| Agency CMO | 0.4% |
| Agency PO | 0.3% |
| Collateralized Loan Obligations | 11.6% |
| Commercial MBS | 14.3% |
| ABS | 4.8% |
| Bank Loan | 3.8% |
| Emerging Markets | 5.5% |
| Non-Agency Residential MBS | 33.9% |
| Other | 1.9% |
| TOTAL | 100.0% |
| FPA Contrarian Opportunity Strategy | |
| Asset Class Exposures | |
| U.S. Stocks | 39.8% |
| Foreign Stocks | 20.6% |
| Bonds | 5.6% |
| Limited Partnerships | 2.9% |
| Cash | 31.0% |
| TOTAL | 100.0% |
Loomis Sayles Absolute Return Strategy
Strategy Exposures
| Long Total | Short Total | Net Exposure | |
| Securitized | 30.6% | 0.0% | 30.6% |
| High-Yield Corporate | 24.7% | -6.5% | 18.2% |
| Investment-Grade Corp. | 17.1% | -3.0% | 14.1% |
| Emerging Market | 4.6% | 0.0% | 4.6% |
| Convertibles | 6.0% | 0.0% | 6.0% |
| Dividend Equity | 4.5% | -0.1% | 4.4% |
| Bank Loans | 1.6% | -0.4% | 1.2% |
| Global Credit | 0.5% | -0.5% | 0.0% |
| Currency | 1.0% | -1.1% | 0.0% |
| Subtotal | 90.7% | -11.5% | 79.2% |
| Cash & Equivalents | 10.4% | 0.0% | 10.4% |
Water Island Arbitrage and Event-Driven Strategy
Sub-Strategy Exposures
| Long | Short | Net | |
| Merger Arbitrage – Equity | 94.6% | -4.3% | 90.4% |
| Merger Arbitrage – Credit | 0.0% | -0.0% | 0.0% |
| Total Merger-Related | 94.6% | -4.3% | 94.6% |
| Special Situations – Equity | 2.0% | -0.2% | 1.8% |
| Special Situations – Credit | 1.6% | 0.0% | 1.6% |
| Total Special Situations | 3.6% | -0.2% | 3.4% |
| Total | 98.2% | -4.5% | 93.7% |