The iMGP Alternative Strategies Fund (Institutional Share Class) gained 0.93% in the final quarter of 2022. During the same period, the Morningstar Multistrategy Category was up 2.50% and the ICE BofA 3-Month Treasury Bill Index returned 0.84%. For the full year, the fund was down 9.49%, compared to a loss of 13.01% for the Bloomberg US Aggregate Bond Index (the Agg), a loss of 2.97% for the category, and a 1.46% 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. To obtain performance as of the most recently completed calendar month, please visit www.imgpfunds.com.
The Alternative Strategies Fund gained almost 1% during the quarter, bringing losses for the calendar year back to the single digits. The fund held up better than traditional assets on the year, beating the S&P 500’s 18.1% loss, high yield bonds’ 11.2% drop, and the Agg’s stunning 13.0% decline. There are no parties being thrown in the office for this result, but in a year as challenging as 2022, sometimes you have to appreciate the (very) small victories. The bright spots for the year were Blackstone Credit Systematic Group’s (fka DCI) more than 4% return on their long-short credit portfolio, and Water Island’s merger and event-driven sleeve’s nearly 1% gain. FPA was down slightly more than 10%, not surprising given the significant losses for equities globally. Our addition of DBi’s Enhanced Trend strategy (trend following complemented by an equity hedge component) proved unfortunately timed, as November produced the worst performance of the year for trend following strategies, with the result that DBi’s portfolio was down over 5% in its inaugural quarter. Of course we wish we had finished our work earlier in the year so we could have enjoyed the benefits the strategy would have provided for most of the year, but we view the allocation as a long-term strategic position, and expect that it will add considerable value over time, despite the early losses. Crucially, we expect it to add the most value in market regime changes like we experienced in 2022, when other strategies – even ones that traditionally perform reasonably well in “normal” bear markets – may struggle. The relative disappointments of course were the low- to mid-teens losses suffered by the long-biased fixed income managers, Loomis Sayles and DoubleLine.
On the flip side of that coin, however, losses in fixed income markets that impacted those managers have produced the excellent opportunity set they currently see. We mentioned some of the underlying subadvisor portfolio metrics last quarter, and we would again highlight how compelling the opportunistic fixed income portfolios are. In fact, as we recently announced, as of early January we implemented a tactical overweight to DoubleLine to take advantage of the opportunity in securitized credit, specifically. As investors familiar with the fund know, we maintain a very high bar to deviate from our strategic allocations, but we find this to be a situation that easily clears that bar. You can find more detail about the move here. On a blended basis, using portfolio metrics as of December 31, 2022, but with the updated subadvisor allocations, the combination of DoubleLine and Loomis Sayles (42% of the fund collectively) has a yield of over 10% and a duration under four years. This seems to us to be a very strong tailwind for performance going forward. Much of what we wrote last quarter about the strong opportunity sets for other subadvisors remains true, if slightly diminished, as reflected by the positive performance for those managers in Q4. Those relative changes in the opportunities available to the subadvisors also factored into our decision to overweight DoubleLine.
As fellow shareholders, we are well aware that it has been a painful year, but we believe the slight gain in the fourth quarter is just the first step on a longer road to potentially higher returns to come in future quarters. We obviously can’t forecast the timing or level of gains (or losses), and the path is never a straight line, but we are as excited about the fund’s potential going forward as we have been in quite some time. We hope you share our enthusiasm. We look forward to reporting back to you after the first quarter, hopefully with continued positive momentum, and we wish everyone a happy, healthy, and prosperous new year.
iMGP Alternative Strategies Fund Risk/Return Statistics 12/31/2022
|Statistics of 9/30/2022||MASFX||Bloomberg US Agg Bond Index||Morningstar US Fund Multistrategy||HFRX Global Hedge Fund||Russell 1000 Index|
|Total Cumulative Return||46.57||17.06||34.96||22.71||318.10|
|Annualized Std Dev||4.78||3.94||4.26||4.16||14.81|
|Sharpe Ratio (Annualized)||0.58||0.19||0.47||0.28||0.89|
|Beta to Russell 1000||0.27||0.07||0.26||0.23||1.00|
|Correlation of MASFX to||1.00||0.32||0.90||0.85||0.83|
|Worst 12-Month Return||-10.04||-15.68||-5.71||-8.19||-19.13|
|% Positive 12-Month Periods||0.79||0.67||0.74||0.68||0.88|
|Upside Capture vs Russell 1000||26.36||7.71||24.85||20.75||100.0|
|Downside Capture vs Russell 1000||27.01||5.03||29.38||27.48||100.0|
|Upside Capture vs Agg||78.89||100.0||66.07||43.08||238.62|
|Downside Capture vs Agg||24.50||100.0||25.00||14.35||13.91|
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, four of the six sub-advisors produced positive returns. The FPA Contrarian Opportunity strategy gained 9.83%, Blackstone Credit Systematic Group’s Long-Short Credit strategy was up 4.87%, the Loomis Sayles Absolute Return strategy increased by 2.39%, and Water Island’s Arbitrage and Event-Driven strategy gained 1.50%. Detracting from returns, DoubleLine’s Opportunistic Income strategy declined 0.77% and the DBi Enhanced Trend strategy fell 5.65% in its first quarter as part of the fund. (All returns are net of the management fee charged to the fund.)
Two of the five managers who were part of the fund for the full year produced positive returns, with Blackstone Credit Systematic Group gaining 4.96% and Water Island up 0.52% for the year. On the negative side, full year performance for FPA was down 10.21%, Loomis Sayles lost 12.10%, and DoubleLine declined 16.62%.
Key performance drivers and positioning by strategy
Blackstone Credit Systematic Group (DCI):
The portfolio returned over 4% net in the quarter and was particularly strong on a relative basis in the month of December with a return over 1%, which was notable amidst the sharp decline in equities, bonds, and credit. Alpha performance was strong for the quarter, driven by the short side of the portfolio against a backdrop of idiosyncratic credit deterioration. Short positioning in retail, home building, and tech provided the largest boost, while longs in industrials, healthcare, and energy were negative contributors.
The portfolio was well hedged over the period and so the macro footprint was limited, but security selection gains in the portfolio were broad-based. With credit deterioration a market theme, the portfolios underweight to high-default-probability names and tilt into stronger credit-quality has been particularly valuable, playing out in both the corporate bond and CDS sleeves.
DCI expects this positive alpha environment to continue as they see the market environment likely to be supportive of future convergence in credit selection, with dispersion in fundamentals and default probabilities both elevated and varied. They anticipate the potential for further gains as the market continues to recognize the divergence in credit quality, as investor expectations transition to an economic retrenchment in the first half of the year.
The Enhanced Trend portfolio declined approximately 5.7% during the fourth quarter. Better than expected inflation data reversed multiple trends across asset classes. The trade weighted US dollar gave back all gains from the previous quarter, the Euro was the primary detractor as it surged 8%, and the long dollar position was reduced by quarter end. Equities initially rallied during the first half of the quarter but faded as Federal Reserve guidance remained hawkish. The whiplash caught other positions off guard as well, gold rose 10% in the quarter, but that commodity had been in a downtrend since March so the portfolio entered the quarter short and took time to change direction. Net long positions in small and midcap stocks did help to dampen losses as did a short crude oil position, which fell over 11% during the last two months of the quarter. A rise in short term yields also helped to partially offset detractions coming from volatile moves in longer dated treasuries.
In 2022, the regime shift in inflation kicked into gear. The “inflation trade” began in early 2021 as a highly contrarian macro call by hedge fund legend Stan Druckenmiller: that a convergence of monetary easing (“Fed will let the economy run hot”), fiscal profligacy (Democrats win Georgia) and pent-up demand post-Covid would trigger the return of inflation. His radical prediction, as DBi wrote about at the time, was that inflation could hit 4-5%.
Initially, few traditional market strategists agreed. After all, a decade of extreme money printing and government spending had failed to light the inflation fire – an awkward outcome for an economics community whose models predicted otherwise. Contrarians who had stuck their necks out years earlier were, at best, labeled Cassandras and, at worst, unemployed. Most traditional portfolios were replete with “low rates forever” bets: whether to support FAANG (Facebook/Amazon/Apple/Netflix/Google) P/E ratios in the S&P 500, near zero (and sometimes negative) fixed income yields or low single digit cap rates in real estate. And those portfolios – built on ten- and twenty-year capital markets assumptions – were designed to move very slowly, run by allocators who are supposed to be calm, steady hands through flighty shifts in market sentiment.
That disconnect defines a regime shift: a sudden macro pivot in an investment world built to move slowly. It also explains why hedge funds – many, but clearly not all – prospered. Some macro funds posted triple digit returns. Managed futures funds detected the signs early, rode the trade for eighteen months, gained 20% last year and delivered half a decade of alpha. More flexible fundamental investors – obviously not tech-focused hedge funds, who were and are structurally neck deep in the low rates trade – de-risked early or pivoted into markets, whether value or non-US, that were historically cheap after a decade of underperformance. Short positions in government bonds and certain currencies – outside the reach of long only allocators – became the “new” inflation hedges after the old playbook (gold, inflation-linked bonds and real estate) failed.
The consensus view today is that inflation has peaked, the global economy will slow and central banks will start cutting rates in a few quarters. That may turn out to be accurate; yet the consensus view often is wrong and flips suddenly based on new data and events. Our gut tells us that this plays out over years: central banks have years of unwinding in front of them; governments will remain addicted to spending even with more punishing borrowing costs; deglobalization will ripple through labor markets, supply chains and corporate profits; the geopolitical backdrop is somewhat frightening with polarization and a land war in eastern Europe; and social and political unrest is likely to spread as inflation bites. DBi’s hope is that hedge funds continue to find ways to protect capital – and better yet, profit – as opportunities present themselves – and that investors in the strategy can hitch along for the ride.
For the quarter ended December 31, 2022, the Opportunistic Income portfolio underperformed the Bloomberg US Aggregate Bond Index (the “Agg”) return of 1.9%. The primary driver of the underperformance was asset allocation. Specifically, the securitized credit holdings in the portfolio underperformed the investment-grade corporate bonds held in the index. In addition, the index also benefitted from its large allocation to US Treasury securities. Despite the relative underperformance, several sectors in the portfolio generated strong, positive returns. The top-performing allocations were Emerging Market (“EM”) debt and Commercial Loan Obligations (“CLOs)”, both of which enjoyed meaningful spread tightening. Spreads for Emerging Market debt especially rallied in response to the Federal Reserve slowing the pace of its policy rate increases. CLO spreads rallied in sympathy with the sharp moves tighter in US investment-grade corporate bond spreads. The worst-performing sector in the Fund was Asset-backed Securities (ABS). This sector is perceived as cyclical in nature and thus experienced some spread widening as investors became increasingly concerned about a recession in 2023.
As has been the case since inception, non-Agency RMBS was the portfolio’s largest sector exposure at year end, accounting for 34%, while Commercial Mortgage Backed Securities (“CMBS”) (16%) and CLOs (14%) were the other major allocations over 10%. Other credit sectors (ABS, bank loans, EM, high yield) collectively made up an additional ~20%. The portfolio ended the quarter with a duration of 4.2 and a yield of 11.7%.
The Contrarian Opportunity portfolio posted a strong quarter (up nearly 10%) to end the year, better than both the S&P 500 and the MSCI ACWI. The top contributors for the quarter were a mix of communications/technology and cyclicals, led by AIG and Holcim (both contributing more than 60bps), followed by Broadcom, Comcast, and Analog Devices (all contributing between 40 and 50bps ). The largest detractors during the quarter were mainly the companies that have been sore spots all year due to the mix of the macro environment causing dramatic valuation contraction and company-specific issues. In declining order of impact, Amazon.com, Alphabet, and Meta Platforms (fka Facebook) collectively cost the portfolio about 0.9%). The portfolio continues to hold these stocks given their still-dominant positions in their industries, much more reasonable valuations, and potential for self-help. (Meta and Amazon are already up more than 10% this year as we write this.) During the quarter, the PMs established new positions in Naspers, Wayfair convertible bonds, and two bank debt positions. Eliminated positions included Flutter Entertainment (on strong price appreciation) and Prosus (essentially a swap for Naspers). There were no material increases or decreases to existing positions.
The equity exposure at quarter end was approximately 66%, while credit exposure was 5% and private investments made up less than 3%. The largest sector concentrations remained in financials, communication services, and industrials. These three sectors made up more than 60% of the equity portfolio. The portfolio exhibits a healthy balance of quality and valuation. The PMs remain cautious but opportunistic, particularly in looking to add exposures to dislocated sectors/assets with asymmetric upside and limited downside, like the basket of busted convertible bonds with substantial yields (above the high yield index) in the base case and the potential for significantly higher returns if the companies’ stock prices rebound. Cash remained a substantial holding at approximately 27%, allowing the PMs flexibility to invest aggressively when they find compelling ideas.
The Absolute Return strategy outperformed the Agg, gaining 2.4% in the fourth quarter. Emerging markets assets were strong contributors to performance, with Chinese and Mexican exposures being primarily responsible. Emerging market assets broadly were helped during the quarter by the softening of the US dollar and China’s move away from its zero-Covid policy. Russia/Ukraine dynamics and a change in administration in Brazil remain key risks for the sector. High yield corporate bond exposure was also a contributor to performance. Spreads tightened during the quarter, as the rebound in markets for risk assets contributed to yield spread compression. The category was broadly helped by lower interest rate sensitivity and higher income relative to investment grade corporates. Consumer names were mostly responsible for the positive impact. Investment grade corporate bond spreads also tightened over the fourth quarter as the emergence of more subdued inflation metrics suggested that we may be past “peak inflation” and allowed central bankers to provide (relatively) dovish guidance for the rate hiking cycle. Investment grade corporates were additive to portfolio performance, with financial and technology names being primarily responsible. There were no materially negative sectors during the quarter. The portfolio ended the quarter with a duration of 2.5 and a yield of 7.8%.
The portfolio generated a return of almost 2% in the fourth quarter. The merger arbitrage positions contributed more than 100% of the gain, while the special situations allocation detracted modestly.
The top contributor in the portfolio for Q4 was the acquisition of Twitter Inc by Elon Musk. In April 2022, Elon Musk – CEO of Tesla and SpaceX and one of the richest people in the world – launched an unsolicited bid to personally acquire the 91% of US social media company Twitter that he did not already own for $54.20 per share in cash. Musk put together a financing package combining commitments from a group of banks led by Morgan Stanley and private equity firms with his own personal assets, including loans backed by his holdings in Tesla stock. Musk’s commitment to the deal seemingly wavered in line with the fortunes of Tesla shares, which traded down significantly after Twitter’s board agreed to the transaction. Musk’s capriciousness led to significant volatility in the deal spread, as he attempted to back out of the deal and Twitter filed suit in the Delaware Court of Chancery to enforce the original merger agreement. Rather than undergo litigation, Musk ultimately capitulated and agreed to close the deal on its original terms. Water Island’s analysis of the strength of the merger agreement (and thus Musk’s likelihood of losing in court) gave them the confidence to maintain exposure to this deal throughout its life. Volatility throughout the deal timeline allowed the PMs to trade around the spread and add exposure at attractive rates of return, and the fund was rewarded when the deal was completed in Q4 2022.
Other top contributors for the period included positions in Aerojet Rocketdyne Holdings and the acquisition of First Horizon Corp by Toronto-Dominion Bank. Aerojet is a position Water Island maintained following the failure of its acquisition by Lockheed Martin due to regulatory objections, as the team believed the company would soon find another buyer based on the background of the Lockheed merger agreement and the presence of an activist investor. Indeed, in Q4 L3Harris Technologies emerged with a bid, leading to gains for the fund. The merger of First Horizon and Toronto-Dominion saw its spread narrow noticeably based on certain regulatory hurdles being achieved as well as fundamentals for bank stocks improving during the quarter; Water Island expects this deal to close in Q1 2023.
Conversely, the top detractor in the portfolio was the failed acquisition of Rogers Corp by DuPont de Nemours Inc. In November 2021, Rogers – a US-based manufacturer and seller of specialty polymer composite materials and components – agreed to be acquired by DuPont – a US-based provider of chemicals, plastic materials, fibers, and consumer products – for $5.3 billion in cash. This transaction experienced an extended regulatory review at the State Administration for Market Regulation (SAMR) in China. In November 2022, when the deal’s termination date was reached with SAMR approval still outstanding, DuPont opted to walk away rather than agree to extend the timeline. This caught many arbitrageurs by surprise, as the companies had jointly reaffirmed their commitment to the merger and desire to reach a resolution with SAMR just two months prior. Speculation around DuPont’s reasons for walking away and year-end tax-loss harvesting exacerbated the price reaction of Rogers shares upon the deal termination, leading them to trade at depressed levels. Water Island is following its deal break protocols and looking to unwind this position on strength as Rogers shares begin to trade at more normalized levels.
Other top detractors included positions in the acquisition of iRobot Corp by Amazon.com and the acquisition of Sierra Wireless by Semtech Corp. The iRobot deal is undergoing a lengthy regulatory review predicated on distrust of “Big Tech” and the security and confidentiality of personal user data to which Amazon would gain access. As this is a horizontal merger, however, the team believes the government’s concerns are baseless and have no grounding in antitrust law, and they expect the merger to close successfully. In a bit of unfortunate timing for those concerned with calendar year performance, the Sierra Wireless deal saw its spread widen after the companies received an unexpected second request from regulators in October, which typically extends a deal timeline about five months. It appears to have been nothing more than a fishing expedition, however, as the transaction received approval just a few days into the New Year and has already closed successfully, less than three months later.
Water Island Market Commentary
In the past year, numerous factors – including geopolitical conflict, soaring inflation, recession fears, lingering after-effects of the COVID-19 pandemic, and the sharpest rise in interest rates since the 1980s – slashed confidence and escalated uncertainty amongst boardrooms and investors, helping deliver the worst-performing year for the bond market and fourth-worst performing year for the stock market in more than 80 years.
The past year was certainly not easy for mergers and acquisitions (M&A), as there were many headwinds to dealmaking. While 2022 began with near-record levels of announced M&A for the first six months of the year, extending the record-setting pace of 2021, deal flow slowed meaningfully in the second half as confidence waned. Despite the slowdown, the total level of deal flow for the year remained consistent with historical averages. Furthermore, as we approached year-end and the rate of inflation began to ebb, confidence grew that the Federal Reserve would pull back on future interest rate hikes and consolidation activity accelerated anew. In this environment, our strategy succeeded in generating a differentiated return stream and preserving investor capital.
We believe the pickup in M&A activity bodes well for deal flow in the year ahead. When the path to organic growth is uncertain, companies often look to grow through M&A. With valuations still depressed, companies may seek to opportunistically make acquisitions at historically low multiples. The most active sectors for consolidation in the months ahead are likely to be those that experienced the worst drawdowns in 2022, such as technology and healthcare. Pharmaceutical and biotechnology companies in particular are under pressure from shareholders to engage in more M&A, as the industries’ biggest players have been sitting on piles of cash. We expect private equity acquirers to remain active as well, given their historic dry powder levels, but such deals may require increased equity and direct-lender participation at this stage of the cycle.
While cash has been the most prevalent form of payment for several years, sellers may increasingly seek to receive a stock component in deal consideration, hoping to recoup some of last year’s losses should the market recover after their deals settle. Conversely, buyers may look to strike more deals with less common forms of consideration, such as a long-term contingent value right component, which can boost a deal’s value several years after close based on the performance of a certain asset. Such uniquely structured transactions can always be topped by the certainty of cash, however, leaving them vulnerable to topping bids. More frequent competitive bidding scenarios may emerge if boardroom confidence improves more broadly and buyers in a position of strength have differing views on valuations (as is often the case following a significant market dislocation).
Going into 2023, all eyes are on Microsoft’s $69 billion acquisition of videogame developer Activision Blizzard, which the Federal Trade Commission (FTC) has sought to block. Other competition regulators, including those in the UK and European Union, have also raised antitrust concerns. While Activision shares are trading around 20% below the offer price, the company is still generating analyst buzz even in a scenario where it remains a standalone company, which could potentially mitigate downside in the event of a deal failure. That risk-reward profile makes it a compelling bet for arbitrage investors. We anticipate regulatory scrutiny of M&A transactions to continue to rise in 2023, with sellers demanding stronger regulatory contract provisions and anticipating longer deal timelines. That said, antitrust regulators have suffered recent losses in court – with Change Healthcare’s victory reinforcing historical precedent, even as regulators attempt to take a novel view of antitrust. We believe this could provide corporations the confidence to push back against overzealous regulators rather than balk and walk away.
We anticipate the market environment will remain characterized by uncertainty and volatility in the near term. As such, we intend to continue to heavily tilt the portfolio toward investments predicated on hard catalyst events, particularly M&A, given their more definitive nature. Post-2008, after more than a decade with a risk-free rate near zero – and this may feel unusual to say – we are finally in a more normalized interest rate environment with the Federal Funds rate above 4%. Whether topping bids materialize or not, we believe these levels will help bolster attractive rates of return for merger arbitrage positions in newly announced deals going forward. Currently, deals with the least perceived risk are trading at levels competitive with two-year Treasury securities, with deal-specific spreads increasing commensurate with deal risk. Ample deal flow and the ongoing presence of market volatility could further aid the fund in alpha generation, though as always, we are cognizant of heightened risk in our space, and we intend to adhere to our stringent risk management protocols as we seek to deliver non-correlated returns.
At year end, the fund’s capital was allocated according to its new strategic targets: 20% each to DBi and DoubleLine, 18% Water Island, 15% each to Blackstone Credit Systematic Group and Loomis Sayles, and 12% to FPA. However, as discussed earlier, as of January 10th, we implemented a tactical overweight to DoubleLine’s sleeve. The current allocations 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. 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, 2022
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top Five Sector Exposures|
|CDS Portfolio Statistics|
|Number of Issuers||76||73|
|Average Credit Duration||4.3||4.4|
|Spread||201 bps||188 bps|
|DBi Enhanced Trend Strategy|
|Asset Class Exposures (Notional)|
|DoubleLine Opportunistic Income Strategy|
|Agency Inverse Interest-Only||8.6%|
|Non-Agency Residential MBS||34.2%|
|Collateralized Loan Obligations||13.9%|
|FPA Contrarian Opportunity Strategy|
|Asset Class Exposures|
Loomis Sayles Absolute Return Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||9.2%||0.0%||9.2%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||92.3%||-2.9%||89.4%|
|Merger Arbitrage – Credit||0.0%||-0.0%||0.0%|
|Special Situations – Equity||0.7%||0.0%||0.7%|
|Special Situations – Credit||1.6%||0.0%||1.6%|
|Total Special Situations||2.3%||0.0%||2.3%|