Commentary Alternative Strategies Fund First Quarter 2021 Commentary

The iMGP Alternative Strategies Fund (Institutional Share Class) gained 2.44% in the first quarter of 2021. During the same period, the Morningstar Multialternative Category was up 2.13% and 3-month LIBOR returned 0.05%.

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.

Quarterly Review

The fund continued to generate solid returns during the quarter, and since the market carnage of Q1 2020, the fund is up 20.14%, compared to 14.54% for the category average, and 0.71% for the Bloomberg Barclays U.S. Aggregate Bond Index (the Agg). The fund received the strongest contribution from FPA’s portfolio, which has benefited from the recovery of value stocks relative to growth this year. This is an oversimplification since FPA maintains very significant positions in high-quality, growing franchises in tech and communications, but the portfolio’s collective exposure to cyclical sectors like financials, industrials, and materials drove strong performance. Other sub-advisors’ performance was more muted, although still positive in all cases except for the very minor decline (net of fees) in the Blackstone Credit (formerly known as DCI) portfolio, which struggled with the sharp rotation in market leadership, as lower-quality credits tended to rally the most during the quarter amid continued investor optimism about economic growth.

We have received several questions from investors about inflation and its potential impact on the fund. Although we are aware of the relevant macroeconomic issues and have our own opinions, those opinions rarely (if ever) impact the way we manage the portfolio in a material way. For us to add value by doing so, we would need to have high-conviction macro views significantly different than those already reflected by the market, be correct in those views, and then have the market react the way we anticipate it would. We believe that combination is challenging to pull off consistently and that a more repeatable way to generate good or better returns relative to risk taken over time is to maintain a portfolio of skilled managers with different strategies and complementary approaches and give them flexibility to respond opportunistically to the conditions they find.

In any case, at this point, we don’t differ significantly from what seems to be the consensus regarding inflation (a short-term pickup due in part to lapping the ultra-low readings of a year ago with the potential for somewhat higher levels medium term, but not jumping so high or sharply that inflation becomes destructive). Thus, we’re not actively (tactically) positioning the portfolio differently from the top down. That said, we think the fund should be reasonably well positioned to handle somewhat higher inflation that comes from stimulative fiscal policy and still-loose monetary policy.

There remains a significant set of exposures that should benefit from (or at least not be hurt by) moderate inflation: the more traditionally cyclical/“value” parts of FPA’s equity book, as well as a lot of the structured credit in the DoubleLine and Loomis Sayles portfolios, much of which is floating rate and more economically sensitive, thus likely to benefit overall from inflation that might accompany stronger economic growth. There are of course parts that could be challenged, like the emerging-market credit positions held by DoubleLine and Loomis (for example, the potential for inflation could cause monetary conditions to tighten sooner than many investors originally expected, as reflected in U.S. dollar strength during the quarter, which is a headwind generally for emerging markets) and high-yielding equities (Loomis). However, those are relatively minor parts of the fund overall. Blackstone should be relatively neutral to inflation since their credit default swap (CDS) book is driven by credit spreads rather than rates, and at the company level, inflation will have idiosyncratic impacts, which should be beneficial in terms of the opportunity set for security selection. Additionally, their high-yield bond portfolio is hedged back to have very limited duration while the general supportiveness of growth-oriented policies should be a tailwind for the credit exposure.

So, on balance, we do not expect somewhat higher inflation to pose a material risk, and it may be modestly beneficial if it is indeed tied to increasing nominal growth. The fund’s historical correlation to the Agg is slightly negative, and the fund’s performance this quarter was good during a negative period for the Agg. We can obviously make no guarantees about future results, but this return profile does make sense to us given the fund’s positioning.

Performance of Managers

For the quarter, four of five sub-advisors produced positive returns. FPA’s Contrarian Opportunity strategy was up 8.81%, the Water Island Arbitrage and Event-Driven strategy gained 3.20%, DoubleLine’s Opportunistic Income strategy returned 1.73%, the Loomis Sayles Absolute Return strategy was up 0.82%, whilethe Blackstone Credit (DCI) Long-Short Credit strategy fell by 0.07%. (All returns are net of the management fee charged to the fund.)

Key Performance Drivers and Positioning by Strategy

Blackstone Credit (DCI)

The Blackstone Credit (DCI) Long-Short Credit strategy declined by less than 0.1% (net) in the quarter on mixed results and crosscurrents in the portfolio. The CDS sleeve was again the detractor for the quarter while the bond sleeve made modest gains. Security selection was challenged in the quarter, especially in CDS, as the renewed rally in beaten-down credits on the back of the economic reopening news drove credit spreads narrower, in particular at the low end of the quality spectrum. DCI’s portfolio has rotated into a number of such “recovery” trades, but again the more-distressed names led the gains and so the short side of the portfolio delivered losses during the quarter. Net beta effects were a positive contributor, with rates being a small negative and credit hedges performing in line. By design, the portfolio construction is focused on asset selection—favoring firms with lower default risk (as measured by DCI’s proprietary default probability model) and improving fundamentals—and designed to be neutral to credit beta. While market dislocations from last year have largely normalized, credit differentiation has recently taken a back seat to the large beta and recovery-rotation trades. Hence, DCI still sees elevated opportunity for credit differentiation as underlying corporate fundamentals come back into focus in 2021. There has been some early evidence of this at the end of March as performance improved and, importantly, the long-short sleeve gained some steady traction, which bodes well for performance going forward.

U.S. Treasury yields took center stage in financial markets, rising 80+ basis points (bps) out the curve as the better economic outlook further stoked reflation expectations, and even the 5-year note was 58 bps higher. The market rotation into recovery sectors and “value” trades was the dominant theme, while growth sectors such as technology and defensives lagged. The S&P 500 Index was up about 5.5% in Q1, with the Nasdaq gaining about half that on the underperformance of large tech companies. Small-cap equities led the way, with the Russell 2000 Index racing ahead, up 12% for the quarter. Oil prices climbed 21%, boosting the energy sector in both equities and credit. The Chicago Board Options Exchange Volatility Index (VIX) ended the quarter below 20, plumbing its lowest levels of the year, but remains elevated compared to past benign environments. Credit spreads generally followed equities. High-yield bonds continued their credit outperformance from the end of last year, outpacing investment-grade bonds, with spreads tightening by 50 bps. Within high-yield, the CCCs outperformed, with their spreads grinding in by 150 bps.

Security-selection alpha was negative based on losses in the CDS sleeve, as high-spread shorts outperformed. Short positions in cruise lines were the largest detractors. Long positions in steel, insurance, retail, autos, and mining were the strongest positive contributors. In bonds, the gains in technology and consumer names (including retail and some hotels and travel) continue to boost the portfolio. Negative offsets were seen in underweights to large energy and telecom index names. The bond portfolio continues to have significant weightings in technology and consumer names, particularly in Internet and entertainment, and is underweight traditional defensives like utilities and telecom. The portfolio is overweight to small energy players and is underweight to the large names. The CDS portfolio is still long steel and mining but has moved closer to neutral within almost all sectors, favoring some auto, retail, and hotels among consumer names. As always, the portfolio is built from the bottom up and favors improving fundamentals and strong credit quality.

DoubleLine

For the quarter, the Opportunistic Income portfolio’s 1.7% return was significantly better than the Agg’s loss of 3.4%. The outperformance was primarily driven by duration positioning and asset allocation. Duration positioning had an especially large impact on relative performance as the portfolio consistently maintained a shorter duration than the index during this period and the 10-year U.S. Treasury interest rate rose by 83 bps. Asset allocation was a secondary driver of outperformance because the portfolio maintained a large exposure to securitized credit products, which firmly outperformed the conventional corporate credit held in the index.

The top-performing sectors within the portfolio during the quarter were asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS). As discussed at the end of 2020, these sectors stood to gain the most from a successful COVID-19 vaccine rollout, and the roughly 580 million doses administered globally during the first quarter certainly helped boost the outlook for these assets. Specifically in ABS, returns were mostly driven by price increases for aviation-related debt, while in CMBS the majority of the return contribution came from investments in hospitality properties. Two other sectors that delivered strong returns were collateralized loan obligations (CLOs) and bank loans. Both of these products pay floating-rate coupons indexed to 3-month LIBOR, which naturally caused their prices to increase as investor expectations for higher growth and higher interest rates began to materialize. The only sector that detracted from performance was agency MBS. This allocation within the portfolio was a top-performer during the 2020 calendar year, but it experienced some duration-related price declines as interest rates rose sharply during the first quarter of 2021.  

The duration ended the quarter at 3.3 years and the yield to maturity was 5.7%. 

FPA

The Contrarian Opportunity portfolio generated strong performance during the quarter, as a recovery in value stocks finally seemed to take hold, on the strength of fiscal stimulus and the acceleration of the COVID-19 vaccinations. Not surprisingly, the top contributors for the quarter were largely financials (American International Group, Jefferies, Signature Bank, and Wells Fargo). Google parent Alphabet was also a top contributor. As a result of some very meaningful gains during the quarter, financials were also among the names trimmed (Jefferies, Signature Bank) or exited (Bank of America, CIT Group). The portfolio managers also exited the final parts of the Puerto Rico municipal bond exposure, producing excellent absolute returns from the deeply discounted purchases several years ago. The largest detractors were Charter Communications, Samsung C&T, an S&P 500 market hedge, and multiple positions across McDermott International’s post-reorganization capital structure. New positions included “new economy” tech/tech-enabled businesses like London-based online betting company Entain and Netherlands-based food delivery company Just Eat Takeaway.

Gross long exposure to equities is approximately 78% and net exposure is approximately 76%. The largest sector concentration is in communication services, with financials and information technology following. These three sectors comprise about half the equity portfolio. Public credit is still under 5% of the portfolio, although the portfolio managers are finding extremely attractive risk-adjusted situations in private credit, with the ability to generate higher yields than public markets with significantly better terms and downside protection. Although this will never be a large part of the portfolio, it remains an attractive area in which to invest. Cash is approximately 20%.

Loomis Sayles

Vaccine optimism and continued policy support also bolstered equity markets during the period. Major U.S. equity indexes ended the first quarter near historic highs. Within the portfolio’s yield-oriented equity allocation, capital goods, utilities, and technology names had the most significant positive impacts on performance. The portfolio’s allocation to securitized assets also contributed positively to performance as consumer and business outlooks have markedly improved since the sector was impacted by COVID-19’s emergence a year ago. The widespread distribution and effectiveness of vaccines provided optimism for economic reopening and supported most securitized subsectors. ABS and non-agency residential MBS issues were the strongest performers in the securitized book.

U.S. high-yield corporate bond spreads meaningfully tightened over the first quarter. The high-yield market benefited from shorter duration and a higher beta relative to most other fixed-income sectors. The scale of the fiscal stimulus bill and the outlook for economic reopening provided additional tailwinds to the asset class. The portfolio’s synthetic exposure via the credit default swap index (CDX) had the most significant positive impact on performance.

Emerging-market assets faced headwinds caused by a stronger U.S. dollar during the first quarter. As inflation expectations continue to rise, monetary tightening may come sooner than expected. Given this context and the memory of the 2013 taper tantrum and bear market that followed, emerging-market assets have struggled. The portfolio’s Mexican, Saudi, and Brazilian exposures were the largest detractors.

The portfolio’s calculated duration is 3.0, with a yield of 4.1%.

Water Island

The Water Island Arbitrage and Event-Driven portfolio generated a net return of 3.2%. Both strategy sleeves contributed to returns with approximately 70% of performance coming from merger arbitrage and 30% from special situations.

Deal Highlights

The top contributor in the portfolio for Q1 was a position in the acquisition of Acacia Communications by Cisco Systems. In July 2019, Cisco—a U.S.-based provider of communications and networking equipment—reached an agreement to acquire Acacia—a U.S.-based manufacturer of fiber-optic transmission hardware—for $3.1 billion in cash. Due to a lengthy review process in China, the deal arrived at its termination date in early January without having received all required regulatory approvals. Acacia, who had seen its business improve significantly in the time since the deal’s announcement, attempted to exercise its right to terminate the transaction. Cisco was clearly committed to acquiring the asset, however, as it sought an injunction preventing Acacia from terminating the deal and—just three days later—the companies announced they had arrived at an amended agreement. Cisco’s revised offer was worth $5.0 billion, more than 60% higher than the original terms. The deal received all remaining regulatory approvals and completed successfully in March, leading to gains for the fund. The fund’s second-best contributor for the period was a merger-arbitrage position in Coherent, a U.S.-based manufacturer of medical and scientific laser systems. In January 2021, Coherent agreed to be acquired by Lumentum Holdings, a U.S.-based optical components provider, for $5.7 billion in cash and stock. Water Island initiated a position in the deal, which led to gains for the fund when a bidding war emerged. Coherent ultimately received nine rounds of bids from three different acquirers, with a $7.3 billion cash-and-stock offer from U.S.-based optical component manufacturer II-VI prevailing. The II-VI transaction is still pending, and Water Island expects it to close by the end of 2021.

The top detractor for Q1 was a position in the acquisition of Change Healthcare. In January 2021, Change Healthcare, a U.S.-based medical software and technology provider, agreed to be acquired by OptumInsight, a subsidiary of UnitedHealth Group (which also owns the country’s largest health insurer) providing medical information technology services, for $13.8 billion in cash. During Q1, the transaction received a second request from the Department of Justice (DOJ), thus extending the deal’s timeline for regulatory review and sending the spread wider. The DOJ’s investigation was prompted, in part, by objections to the deal from the American Hospital Association, which claimed it could curtail competition. Water Island continues to maintain exposure to the deal, although they are monitoring the situation closely. The second-largest detractor for the period was a position in the acquisition of Alexion Pharmaceuticals by AstraZeneca. In December 2020, spurred by an activist campaign from Elliott Management, Alexion—a biopharmaceutical company focused on treatments for rare diseases—agreed to be acquired by pharmaceutical giant AstraZeneca for $40.1 billion in cash and stock. Fears that the Federal Trade Commission (FTC) intends to take a hardline stance on pharmaceutical mergers under the Biden administration have conspired to drive this spread wider. Similar to Change Healthcare, Water Island continues to maintain cautious exposure to the position.

Water Island Market Commentary

As we have mentioned in prior commentary, in our experience, a market shock similar to that of just one year ago is often followed by an initial slowdown in announced mergers and acquisitions, after which consolidation activity rebounds quickly. We began to witness such a trend in the second half of 2020, when nearly 2/3 of the deals announced last year were inked. This surge in deal-making continued into the first quarter of 2021. According to Dealogic data, more than $1.4 trillion in deals were announced during the quarter, rising 114% from the year-over-year period and setting a record for Q1 mergers & acquisitions (M&A) volume.

The source of M&A activity has been broad based, spanning industries from technology and semiconductors to health care and commodities. While deal flow between strategic operators has remained strong, we have seen a spike in financial sponsor M&A, which also set a Q1 record after rising nearly 143% from Q1 2020 to $386 billion. Private equity (PE) firms, which have been sitting on massive amounts of dry powder for several years, are finally putting that money to work. One factor behind this level of activity may be the low valuations PE firms are discovering—despite the recent market rally, the median valuation multiple on transactions resulting in a change in control is now at its lowest level since 2009, according to Dealogic.

Another trend we have discussed in prior commentary is the rise in competitive bidding situations coming out of a downturn. This was a common theme following the Global Financial Crisis, and indeed, during the first quarter of this year we saw topping bids in several deals. Cubic received competing bids from strategic and financial buyers; after shareholders for PluralSight and KAZ Minerals deemed initial bids for the companies insufficient, their respective acquirers both came back with better offers; Cisco Systems topped its own bid for Acacia Communications by more than 60% in order to keep the company at the table after the original deal arrived at its termination date due to delays in the regulatory review process; and an all-out bidding war emerged for Coherent, which received nine different rounds of offers from three different acquirers. Situations like these are not uncommon when acquirers have different views of the market—for example, one company may be more optimistic about the prospects for a recovery, while another may be factoring more risks or bad outcomes into their valuation of the target. We expect this dynamic to continue in the near term, as we believe opinions could vary wildly so long as market volatility and uncertainty around the COVID-19 recovery remain.

Given the current breadth of attractive opportunities in the M&A space and their highly definitive nature, our recent focus in the portfolio has primarily been directed at merger arbitrage. That said, we would be remiss not to discuss the landscape for other investments—special purpose acquisition companies (SPACs), in particular. SPACs have garnered significant attention from the investing public over the past year. While SPAC investments can take several forms, the purchase of a SPAC IPO is the most traditional—and these investments have historically offered both low risk and relatively low reward, with a profile that made them suitable as a yield or cash alternative strategy with some upside potential. Yet in 2020, we believe the SPAC market went, frankly, bonkers. To be fair, we capitalized on this opportunity and SPACs were broadly profitable for the portfolio last year. But while we agree SPACs are here to stay and may be increasingly viewed as a valid alternative to an IPO for companies seeking to go public, during Q1 we grew increasingly concerned about a SPAC bubble. (At the end of March, over 100 de-SPAC transactions were pending, well over 400 SPACs were outstanding, and still more SPAC IPOs were in the pipeline.) Ultimately, the froth in the SPAC space became too much for us to bear, and in February we began cutting our SPAC exposure and implementing SPAC hedges across the positions we chose to continue to own in the portfolio. Our timing proved fortuitous, as investors declared enough was enough and mid-February marked the top for the SPAC market—for the time being.

For event-driven strategies, the more activity that exists, the better. In our view, there is no shortage of high quality, catalyst-driven opportunities, particularly with ample stimulus helping support ongoing corporate activity. The pipeline for M&A remains robust, and we expect merger arbitrage to remain our focus due to its hard catalyst nature. The primary risk we foresee is the upcoming changing of the guard at U.S. regulatory agencies. The arrival of the Biden administration brings with it several key roles to be filled at the FTC, DOJ, and Federal Communications Commission. As such, we anticipate antitrust reviews will become more rigorous and lengthy, especially in high profile sectors such as telecommunications, technology, and health care. We intend to be selective about our soft catalyst exposure, though we may find attractive investments in speculative M&A given the magnitude of the opportunity set in the near term. We may also see a wave of restructuring transactions in certain sectors such as energy and travel and leisure. As always, we intend to adhere to our stringent risk management approach while seeking to capitalize on volatility as we pursue non-correlated returns generated from the outcomes of idiosyncratic corporate events rather than from overall market direction.

Strategy Allocations

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, 2021

Blackstone Credit (DCI) Long-Short Credit Strategy

CDS Portfolio Statistics:

CDS Portfolio Statistics:	Long	Short
Number of Issuers	73	69
Average Credit Duration (yrs.)	4.9	5.0
Spread	118 bps	113 bps

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 3/31/21
Cash	8.0%
Government	6.1%
Agency Inverse Interest-Only	9.7%
Agency CMO	0.6%
Agency PO	0.5%
Collateralized Loan Obligations	8.1%
Commercial MBS	12.5%
ABS	5.5%
Bank Loan	6.5%
Emerging Markets	5.8%
Non-Agency Residential MBS	32.8%
Other	3.8%
Total	100.0%

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 3/31/21
U.S. Stocks	47.0%
Foreign Stocks	30.8%
Bonds and Loans	2.9%
Limited Partnerships	0.9%
Short Sales	-1.9%
Cash	20.2%
Total	100.0%

Loomis Sayles Absolute Return Fixed-Income Strategy

	Long Total	Short Total	Net Exposure
High-Yield Corporate	35.6%	-0.7%	34.8%
Securitized	30.4%	-0.4%	30.0%
Investment-Grade Corp.	14.1%	0.0%	14.1%
Dividend Equity	9.4%	-0.7%	8.7%
Emerging Market	6.7%	-1.9%	4.8%
Convertibles	6.7%	0.0%	6.7%
Bank Loans	0.6%	-0.2%	0.4%
Global Credit	0.4%	-0.3%	0.1%
Global Rates	1.4%	-0.2%	1.2%
Subtotal	105.1%	-4.4%	100.7%
Cash & Equivalents	8.6%	0.0%	8.6%

Water Island Arbitrage and Event-Driven Strategy

Sub-Strategy Exposures

	Long	Short	Net
Merger Arbitrage – Equity	82.8%	-29.2%	53.6%
Merger Arbitrage – Credit	1.2%	-0.2%	1.1%
Total Merger-Related	84.0%	-29.3%	54.6%
Special Situations – Equity	5.1%	–0.2%	5.0%
Special Situations – Credit	3.2%	0.0%	3.2%
Total Special-Situations	8.3%	-0.2%	8.1%
Total	92.3%	-29.5%	62.8%