Commentary Alternative Strategies Fund Second Quarter 2021 Commentary

The iMGP Alternative Strategies Fund (Institutional Share Class) gained 1.63% in the second quarter of 2021. During the same period, the Morningstar Multistrategy Category was up 2.68% and 3-month LIBOR returned 0.04%. For the first half of 2021, the fund gained 4.12%, compared to returns of 5.53% and 0.09% for the Morningstar category and 3-month LIBOR, respectively.

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 had a fine, if unspectacular quarter. Returns across managers were more compressed this quarter, with all five positive, but the range was only a little more than three percentage points from highest to lowest. The main driver of the more muted performance in Q2 compared to Q1 was FPA’s smaller increase relative to its high single digit return in the first quarter. Other performance differences between managers were smaller and largely offset each other. FPA and the fund were hurt on a relative basis by the significant reversal of the value-outperforming-growth dynamic in June, as well as by idiosyncratic issues related (ironically) to some Internet/tech holdings. FPA remains the top-performing sub-advisor for the year and since inception. Water Island, though also positive for the quarter, was hurt in June too, as regulatory concerns sent a shiver through the merger-arbitrage community, reminding participants that the strategy is also called “risk arbitrage” for a reason. We don’t mean to imply Water Island has been a poor performer—to the contrary, they are the second-best performer in the fund this year and over the trailing three years. Though the impact to the portfolio was relatively minor, on the margin it helped contribute to a slightly disappointing end to a good first half of 2021.

The flipside to bumps in the road, as we’ve often noted, is better opportunities going forward. In the case of Water Island, deal spreads are more attractive now, allowing for better prospective returns if managers pick the right deals and avoid or minimize ones with significant challenges. While this bump in the road is minor compared to the hill (or mountain?) encountered in Q1 2020, the principle is the same, and requires the same discipline and risk awareness from managers to be positioned to benefit on the other side, which we saw pay off during the year following the depths of market chaos in March 2020. This certainly isn’t close to the same magnitude, but in the context of a market with much less low-hanging fruit (the VIX is at roughly half the level of a year ago and credit spreads are close to all-time tights), we’ll take opportunities where they are presented. We feel good about the fund’s 13.44% trailing one-year return but don’t expect to match that in the next 12 months, barring something unusual happening. That said, the portfolio is still benefiting from a nice tailwind of structured credit recovery in DoubleLine’s portfolio (and Loomis Sayles’s, to a lesser extent). Combined with what should be a good environment for merger/event investing with huge deal volume and plenty of dry powder remaining in private equity, the cupboard is far from bare, and we know there will always be new opportunities that emerge. With reasonably conservative positioning, the fund’s sub-advisors should be well-positioned to take advantage.

Performance of Managers

For the quarter, all five sub-advisors produced positive returns. FPA’s Contrarian Opportunity strategy was up 3.54%, the Loomis Sayles Absolute Return strategy was up 2.85%, DoubleLine’s Opportunistic Income strategy returned 1.87%, the Water Island Arbitrage and Event-Driven strategy gained 0.90%, andthe DCI Long-Short Credit strategy increased by 0.31%. (All returns are net of the management fee charged to the fund.)

Key Performance Drivers and Positioning by Strategy

Blackstone Credit (DCI)

The Long-Short Credit strategy returned approximately +0.3% in Q2, reversing its slight decline last quarter. Despite struggling amidst the continued strong recovery rally over the last year, credit selection gained some traction during the quarter. DCI expects the forward environment to be supportive of convergence in credit selection, as dispersion in fundamentals and default probabilities are both elevated and varied, and they anticipate that credit fundamentals will re-assert themselves over the course of the re-opening phase of the economic recovery.

The credit-default swap (CDS) sleeve was a small positive, rebounding a bit, and the Bond sleeve generated some steady alpha on the back of credit selection. Beta effects in the portfolio were about flat, as both rates and net credit exposure currently remain well-controlled and low. This has been an important point this year amidst the increasing volatility in rates and credit beta, and hence the returns are uncorrelated with market factors.

The portfolio’s excess returns were tempered in Q2, as lower-rated firms continued to benefit from recovery, with the portfolio’s gains led by long positions in the broad energy sector. The portfolio also benefited from selection in consumer names as well as from names in the materials and finance sectors. The portfolio has tended to remain somewhat short recovery names (especially cruise lines), which was a drag in Q2, but balanced against some longs in travel and transport, as well as the energy names. This balance is somewhat comforting as COVID-uncertainty remains elevated. Energy remains interesting because the sector recovery has gained traction even as name dispersion remained elevated. The model sees further opportunities among energy names here due to the improving conditions generally and wide dispersion of fundamentals, and the steady rise in oil prices has been a growing tailwind. The risk spend is, as usual, idiosyncratic in nature based on company-specific drivers, and the portfolio continues to be unusually neutral in most sectors.

DoubleLine

For the quarter, the Opportunistic Income portfolio’s 1.9% return was slightly ahead of the Bloomberg Barclays US Aggregate Bond Index (the Index) return of 1.8%. The outperformance was primarily driven by asset allocation as the portfolio held significantly more credit-related assets than the benchmark and credit-related assets performed well during this period.  

The largest contributors to performance in the portfolio were non-Agency residential mortgage-backed securities (RMBS), non-Agency commercial mortgage-backed securities (CMBS), and collateralized loan obligations (CLOs). Non-Agency RMBS enjoyed steadily positive returns throughout the quarter as the U.S. housing market remained on solid footing and investors favored real estate–related assets in the face of high monthly inflation readings. Non-Agency CMBS was another key driver of returns as the full reopening of major metropolitan areas such as New York City and Los Angeles sparked an uptick in foot traffic at prominent leisure and hospitality properties. Lastly, the CLO allocation within the portfolio generated sizeable gains as loan defaults remained low and spreads on BB-rated CLO debt tranches compressed further.

There were no detractors from performance—every sector in the portfolio generated positive returns during the quarter. The duration ended the quarter at 3.2 years and the yield to maturity was 5.9%. 

FPA

The Contrarian Opportunity portfolio produced more modest gains of 3.5% during the quarter, as cash increased slightly and “growth” generally outperformed “value,” with a particularly sharp move in June. Although the portfolio maintains significant exposures to high-quality, growing companies, the ~35% weighting in traditional value sectors proved to be a drag on relative performance. The top contributors for the quarter were Alphabet, Facebook, Charter Communications, Analog Devices, and Wells Fargo, while the largest detractors were in multiple positions across McDermott International’s post-reorganization capital structure, and several foreign technology and tech holding companies, including Nexon, Softbank, and Naspers and Prosus, which struggled as their discounts to the underlying holding in Tencent widened despite continued efforts to address the issue. New positions included consumer/tech companies Ubisoft and Netflix, as well as online betting company Flutter Entertainment. (The portfolio managers also increased exposure to Entain, the other online betting company that was purchased earlier this year.) In an interesting opportunistic move, FPA added a basket of SPACs right around or very slightly below trust value after the “sector” sold off sharply from the unsustainably exuberant heights it reached in February. The basket is very diversified and accounts for only about 2% of the portfolio but provides free optionality that could add to returns if the market is excited by any of the deals the SPACs announce.

Gross long exposure to equities is approximately 74% and net exposure is approximately 72%. The largest sector concentrations remain communication services, financials, and information technology. Credit is under 3% 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, FPA intends to selectively add to it. Cash is almost 25%.

Loomis Sayles

The Absolute Return strategy delivered solid performance during the second quarter, gaining 2.9%. The portfolio’s allocation to equities performed well as many of the same macroeconomic factors supporting other risk assets also propelled equity markets. The Fed’s policy signaled its belief that higher inflation is transitory, supporting continued market optimism, further bolstered by vaccine efficacy and successful, large-scale distribution efforts. Within the equity portfolio, technology, communications, and capital goods issues had the most significant positive contributions to performance.

Securitized assets also helped performance as consumer and business outlooks continued to improve on optimism around vaccine distribution and economic reopening. Since the sector was impacted by COVID-19’s emergence during the first quarter of 2020 and subsequent knock-on consequences, the reopening success continues to drive good performance in these asset classes. The portfolio’s allocation to ABS was primarily responsible for the sector’s positive impact on quarterly performance, while CMBS and non-Agency RMBS issues contributed more modestly.

Investment-grade corporate bond spreads narrowed slightly during the second quarter, as the sector continued to perform well. Recent, continued labor market softness, in the form of underwhelming jobs data, supported the Fed’s position of lower rates for longer. This contrasts with inflation figures that suggest to many market participants that tapering will need to come sooner than the Fed has indicated. As liquidity and earnings remain solid, China remains a key growth risk as inflation has catalyzed tapering. For the portfolio, investment-grade corporates contributed to performance, with financial, capital goods, and consumer cyclical names adding most.  

Global rates tools, primarily sovereign bonds and interest rate futures, detracted from performance. During the quarter, the yield of the benchmark 10-year U.S. Treasury fell 29 bps, ending the second quarter at 1.45%. Within the portfolio, short exposure to U.S. Treasury futures (used to hedge interest rate risk) were responsible for the majority of the allocation’s negative performance.  

The portfolio’s calculated duration is 1.7, with a yield of 2.9%.

Water Island

The Water Island Arbitrage and Event-Driven portfolio generated a net return of 0.9%. Both strategy sleeves were positive, but the overwhelming majority of contribution came from merger arbitrage.

Deal Highlights

The top contributor in the portfolio for Q2 was a position in the acquisition of Alexion Pharmaceuticals by AstraZeneca. In May 2020, activist investor Elliott Management called on Alexion, a U.S. biopharmaceutical company, to explore a sale. The process led to a definitive agreement to be acquired by U.K.-based peer AstraZeneca for $40 billion in cash and stock. During the quarter, favorable developments—including shareholder approval at Alexion and the receipt of regulatory approval from the Federal Trade Commission—caused the deal spread to tighten, leading to gains for the portfolio. Water Island expects the deal to close in Q3 2021. The portfolio’s second-best contributor for the period was a merger-arbitrage position in the acquisition of Welbilt by Middleby, both U.S.-based manufacturers of commercial food service equipment. The deal was announced in April 2021, with Middleby offering $2.9 billion in cash. The following month, Welbilt received an unsolicited all-cash offer from Ali Group, an Italy-based peer, valuing the company at $3.3 billion. While Middleby’s deal is officially still pending, Welbilt management has stated Ali Group’s bid likely represents a superior offer. If Middleby fails to raise its bid, Welbilt may opt to sign the competing merger agreement. The topping bid led to gains in the portfolio, and Water Island continues to monitor this situation.

The top detractor for Q2 was a position in the acquisition of Xilinx by Advanced Micro Devices (AMD). In October 2020, Xilinx—U.S.-based semiconductor manufacturer—agreed to be acquired by local peer AMD for $35.7 billion in stock. The transaction continues to experience volatility in the deal spread, primarily stemming from concerns related to regulatory review and sour U.S./China relations (with approval in China being a condition of the deal). Water Island is maintaining exposure as they still have conviction the transaction will reach a successful conclusion before the end of 2021. The second largest detractor for the period was a position in the merger of U.S.-based railway company Kansas City Southern and transportation company Canadian National Railway. After a bidding war with Canadian Pacific Railway, Canadian National reached an agreement to acquire Kansas City Southern for $33.6 billion in cash and stock in May 2021. The transaction has experienced volatility in the deal spread due to fears it will face heightened regulatory scrutiny under the Biden administration, leading to losses in the portfolio. As Kansas City is the smallest of the major North American railroads, Water Island believes there is a strong chance the deal will ultimately win approval, and with Canadian Pacific likely still waiting in the wings if it does not, the portfolio managers are maintaining exposure to the position.

Water Island Market Commentary

With the current risk-free rate—a key component of merger-arbitrage deal spreads and one of the core pillars of the strategy’s return potential—essentially hovering around zero, one could be forgiven for wondering if merger arbitrage is fated to exhibit lackluster returns in the months ahead. But the strategy’s other two pillars—deal flow and volatility—have emerged to buoy spreads in dramatic fashion, while a continuation in the phenomenon of topping bids is providing a healthy boost.

The recent surge in mergers & acquisitions (M&A) activity continued through the second quarter of the year, with the first half of 2021 handily marking the most active half-year on record at nearly $3 trillion in announced deals, according to Dealogic data. Activity has been broad-based across sectors, although the level of consolidation in the technology space is particularly notable. Private equity buyers continue to put dry powder to work. The level of financial sponsor activity also set a half-year record at $487 billion in announced deals, surpassing even the first six months of 2007. We expect this activity to continue, as private equity (PE) shops still have ample levels of dry powder on hand. Such breadth of announced deal activity not only allows arbitrageurs to be more selective and diversify a portfolio across a greater number of transactions, but it also spreads the total amount of dollars dedicated to the strategy across a larger universe, which can help support wider spread levels.

During 2021, the portfolio has been largely immune from spikes in broader market volatility. A primary driver of such volatility has been the specter of rising inflation, which has put many investors in a cautious position. But whether elevated inflation will be sustained or short-lived, we believe our event-driven strategies are well positioned to weather its impact. Merger arbitrage generally benefits from interest rate hikes—a tool commonly used to battle inflation—as rising rates typically act as a tailwind to returns. In addition, investments in our catalyst-driven credit strategy are typically characterized by short durations to events, averaging well under a year. That said, the portfolio has not been immune to volatility internal to the strategy, which was especially elevated during the final weeks of the quarter. The impetus was two-fold, when on consecutive days Lina Khan was sworn in as Chair of the FTC and the Department of Justice (DOJ) sued to block Aon’s acquisition of Willis Towers Watson. Following the election of President Biden, we had been eyeing the changing of the guard across regulatory agencies as a likely source of heightened risk for the merger-arbitrage strategy. It is all but certain a more stringent approach will be taken toward antitrust review in the United States, with some appointees—notably, Ms. Khan—arriving with fairly novel views of competition law (some of which are at odds with existing legal precedents). We expect an increase in contentious and lengthy regulatory reviews, litigation, and potentially even new legislation to result, plus a fair amount of spread volatility along the way. The volatility is not wholly unwelcome, however, as it can provide opportunistic entry points in deals where we have high conviction. The news of the DOJ’s lawsuit against Aon, for example, led less confident arbitrageurs to exit a broad swath of deals with even a whiff of regulatory risk, sending spreads wider and allowing us to put dry powder to work at favorable rates of return.

As event-driven investors, our objective remains to generate returns sourced from the outcomes of idiosyncratic corporate events, rather than from the overall direction of broader credit or equity markets. At the same time, we seek to mitigate risk, with a goal of delivering our non-correlated return streams with as little volatility as possible—yet we believe volatility in the strategy could remain higher than normal in the near term. Decades of event-driven investing have taught us conviction and staying power are vital in such times, and we are prepared to capitalize on the opportunities that will present themselves in the months ahead.

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 June 30, 2021

Blackstone Credit (DCI) Long-Short Credit Strategy

CDS Portfolio Statistics:

CDS Portfolio Statistics:	Long	Short
Number of Issuers	81	77
Average Credit Duration (yrs.)	4.7	4.8
Spread	122 bps	125 bps

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 6/30/21
Cash	3.5%
Government	6.4%
Agency Inverse Interest-Only	11.3%
Agency CMO	0.5%
Agency PO	0.4%
Collateralized Loan Obligations	9.6%
Commercial MBS	12.9%
ABS	5.7%
Bank Loan	6.5%
Emerging Markets	5.8%
Non-Agency Residential MBS	33.9%
Other	3.5%
Total	100.0%

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 6/30/21
U.S. Stocks	45.7%
Foreign Stocks	28.3%
Bonds and Loans	2.1%
Limited Partnerships	0.8%
Short Sales	-1.5%
Cash	24.6%
Total	100.0%

Loomis Sayles Absolute Return Fixed-Income Strategy

	Long Total	Short Total	Net Exposure
Securitized	30.9%	-0.2%	30.7%
Investment-Grade Corp.	18.2%	0.0%	18.2%
High-Yield Corporate	14.3%	-0.7%	13.7%
Dividend Equity	11.7%	-0.5%	11.2%
Emerging Market	7.7%	-1.9%	5.8%
Convertibles	6.6%	0.0%	6.6%
Global Rates	1.4%	-0.3%	1.2%
Bank Loans	1.1%	-0.2%	0.9%
Global Credit	0.4%	-0.3%	0.1%
Subtotal	92.3%	-4.0%	88.3%
Cash & Equivalents	7.7%	0.0%	7.7%

Water Island Arbitrage and Event-Driven Strategy

Sub-Strategy Exposures

	Long	Short	Net
Merger Arbitrage – Equity	102.1%	-36.3%	65.8%
Merger Arbitrage – Credit	1.2%	-0.2%	1.0%
Total Merger-Related	103.3%	-36.5%	66.8%
Special Situations – Equity	1.1%	0.0%	1.1%
Special Situations – Credit	4.4%	-0.1%	4.3%
Total Special-Situations	5.5%	-0.1%	5.5%
Total	108.8%	-36.5%	72.3%