Commentary Alternative Strategies Fund Third Quarter 2021 Commentary

The iMGP Alternative Strategies Fund (Institutional Share Class) declined by 0.61% in the third quarter of 2021. During the same period, the Morningstar Multistrategy Category was down 0.32% and 3-month LIBOR returned 0.03%. For the year-to-date period through September 30, the fund gained 3.49%, compared to returns of 5.20% and 0.12% 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 produced a small loss during the quarter, as very modest gains in two of our managers’ portfolios weren’t enough to offset slightly negative performance in the other three strategies. Overall, despite the noisy headlines and investor concerns about Fed tapering, China’s regulatory crackdown/Evergrande, U.S. stagflation, and the U.S. debt ceiling fight, it was a relatively stable quarter performance-wise for most markets. Some notable exceptions include emerging-markets stocks (the MSCI Emerging Markets Index was down over 8% in the quarter) and commodities (the Bloomberg Commodity Index was up almost 7%).

Given that backdrop of relative calm, it’s not surprising to us that the fund was little changed. The attractive yield produced by the fund’s credit managers was offset by losses in a few notable areas. First, the merger arbitrage community suffered significant losses, with few managers escaping unscathed, after Aon’s attempted acquisition of Willis Towers Watson was ultimately scrapped in July following the Department of Justice suing to block it in June. This was a significant position across merger arb/event-driven managers, and the deal break triggered waves of “de-risking” across the space, leading to broader losses. Water Island’s portfolio was of course impacted, leading to modestly negative returns for the quarter (although they generated positive performance in August and September). China also created headwinds for the fund, as FPA’s portfolio took losses on China internet names (such as Alibaba and Baidu) that sold off sharply. Additionally, the continuing fallout from the Evergrande saga hurt the prices of Chinese property-related bonds that Loomis had begun building positions in (at large discounts and attractive expected returns even assuming some restructurings in the sector). Neither of these exposures are large weightings at the overall fund level, although if dislocations continue or worsen, we could see increased position sizes if our managers believe they represent compelling opportunities. Dislocations, if properly risk-managed (as it is seldom easy to bottom-tick positions), present the chance for outsized returns in the future.

Celebrating 10 years

The fund reached its 10-year anniversary at the end of the quarter and we are happy to report that it received a 5-star Overall Morningstar Rating^TM out of 127 Multistrategy funds based on risk-adjusted return. (We wrote a 10-year anniversary Q&A you can read here for more information.) As a reminder, we originally created the fund because we couldn’t find high-quality options in the marketplace for our own clients. There were a number of problems, chief among them that fees were too high, management quality was often mediocre, and we perceived that many seemed to emphasize “style over substance” in an effort to woo investors. We believed the most reliable way to build a successful fund was to combine skilled and complementary managers, give them flexibility (with appropriate oversight), and keep fees reasonable. We wanted managers who combined a risk-averse mindset with a willingness to opportunistically become more offensive-minded when the reward-to-risk ratio is particularly compelling. We believed this approach, combined with somewhat more systematic strategies for capturing some “alternative risk premia” (e.g., merger arbitrage), would be a way to generate good returns over the long run while also protecting against large drawdowns.

With 10 years behind us, the approach has been successful. The fund’s absolute performance has been good, while suffering dramatically smaller drawdowns than equity markets and effectively diversifying (and outperforming) core bonds — in line with what we believe investors are looking for in a lower-risk alternatives fund. We believe this approach will continue to work well and that the coming years could be a better environment for the fund relative to traditional asset classes, particularly given what seems like a very poor starting position for core bonds currently. We will persist in looking for ways to improve the fund over time, continuing to evaluate other strategies that are attractive on a standalone basis while creating additional diversification benefits, although we will keep a high bar and will maintain a concentrated portfolio of subadvisors. Thank you for your confidence in the fund. Our own confidence is reflected in the sizable investments from the fund’s portfolio managers and iM Global Partner employees. We look forward to continuing the journey together.

Quarterly Portfolio Commentary

Performance of Managers

For the quarter, two sub-advisors produced positive returns, with DoubleLine’s Opportunistic Income strategy gaining 0.20%, and the Loomis Sayles Absolute Return strategy up 0.16%. Three sub-advisors produced negative performance: DCI’s Long-Short Credit strategy declined by 0.48%, the Water Island Arbitrage and Event-Driven strategy lost 1.15%, and FPA’s Contrarian Opportunity strategy was down 1.19%. (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 Credit portfolio returned approximately -0.5% in Q3 2021, reversing its gain from the prior quarter. Performance from credit selection slid back modestly during the quarter.

The CDS sleeve was negative, as single-name derivative moves whipsawed, and alpha was challenged. The bond sleeve generated modest gains on the back of credit selection. Beta effects were muted, as both rates and net credit exposure remain well-controlled. This has been an important point this year amidst the increasing volatility in both rates and credit betas and hence the returns have been uncorrelated with market factors. DCI expects the forward environment to be increasingly supportive of potential convergence in credit selection (spread movement toward “fair value”), as dispersion in fundamentals and default probabilities are both elevated and varied. The team anticipates that credit fundamentals will re-assert themselves during the continuation of the re-opening phase of the economic recovery.

Portfolio excess returns were down in Q3 as lower-quality firms continued to benefit from recovery and markets gyrated. Reversals in a few single-name CDS positions hurt the portfolio with gains otherwise broadly offsetting losses. The portfolio was up in Aerospace but down in Consumer and Investment Vehicles. The Energy sector was about neutral in CDS but provided a boost in bonds. The bond sleeve also benefitted from selection in Technology and REITS. The portfolio has continued to emphasize idiosyncratic selection, moving near neutral in most sectors.

The portfolio has gotten somewhat net long financials via finance companies and REITS, and is now net short in materials and transports. The portfolio is about neutral to COVID-recovery names but is long Energy. 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, while the steady rise in oil prices has been a growing tailwind. The great majority of the portfolio’s risk is, as usual, based on idiosyncratic credit selection rather than beta, and the portfolio continues to be close to neutral in most sectors.

DoubleLine

For the quarter the DoubleLine Opportunistic Income portfolio’s 0.2% gain outperformed the Bloomberg Barclays US Aggregate Bond Index return of 0.05%. The outperformance was primarily driven by asset allocation as yield curve changes were minimal and the credit-related assets in the Fund sharply outperformed the Treasuries and Agency-backed bonds held in the Index.

The largest contributors to quarterly performance were non-Agency RMBS, CMBS, and ABS. These sectors enjoyed another strong quarter that featured declining delinquency rates, steady interest income distributions, and moderate price increases as investors continued to favor real-estate and consumer-related assets in the face of a prolonged inflationary environment. CLOs, bank loans, and domestic high yield bonds also generated positive returns as corporate earnings were strong and default activity was low.

The only sectors that detracted from performance were Agency MBS and emerging market debt. The derivatives within the Agency MBS portfolio experienced some price declines due to changes in the front end of the yield curve while the emerging market holdings saw small losses as some areas continue to struggle with relatively low rates of vaccination against COVID-19. The portfolio has a duration of 3.0 and a yield of approximately 5.7%.

FPA

The Contrarian Opportunity portfolio declined by about 1.2% during the quarter. The top contributors for the quarter were Meggitt (0.5%), Alphabet (0.4%), AIG (0.4%), Aon (0.4%), and Glencore (0.3%). Meggitt, an aerospace and defense supplier and longtime portfolio holding that was severely impacted last year by the global pandemic, agreed during the quarter to sell itself to Parker-Hannifin at a price above its pre-COVID high, generating strong returns for the portfolio. The largest detractors for the quarter were again driven by fear of the Chinese crackdown on tech giants. Naspers & Prosus (-0.5%), both indirect plays on Tencent given their significant holdings of the company, and Alibaba (-0.3%) were material detractors. Holcim (-0.5%), Nexon (-0.2%), and the Softbank/Softbank Group pair trade (-0.2%) rounded out the most significant detractors. New positions throughout the quarter included Activision and Amazon, and FPA added to Flutter Entertainment, JDE Peet’s, and Ubisoft. Equity positions in Meggitt and Booking Holdings and fixed-income exposure in BJ Services and Royal Caribbean were trimmed during the quarter.

Gross long exposure to equities is approximately 73% and net exposure 72%. The largest sector concentrations remain communication services (approximately 20%), financials (about 15%) and information technology (almost 10%). Credit remains a small part of the portfolio (<5%), 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 makes up approximately 25% of the portfolio, providing dry powder for opportunistic deployment.

Loomis Sayles

The Absolute Return strategy was slightly positive during the quarter, gaining 0.2%. Securitized assets supported performance, as consumer and business outlooks continued to improve despite the emergence of recent coronavirus variants. Positive sentiment around vaccine distribution and economic reopening were key tailwinds. The allocation to ABS was primarily responsible for the sector’s positive impact on quarterly performance, with CMBS, non-Agency RMBS and CLO issues also contributing.

High-yield corporate bond spreads widened during the third quarter. A lower duration profile relative to investment-grade bonds helped the high-yield market as the Fed continues to weigh labor market and inflation dynamics in determining the pace and timing of potential rate hikes. Within the portfolio, financial and consumer cyclical issues were mostly responsible for the sector’s positive performance.

Emerging-market assets faced headwinds caused by a stronger U.S. dollar and bouts of volatility during the third quarter of the year. Despite what seemed like persistently negative news coming out of China during the latter half of the period, emerging-market issues broadly benefitted from above-average yield and broader strength among higher-risk assets. However, within the portfolio, emerging-markets assets detracted from performance, with Chinese and Mexican exposures most responsible.

The equity allocation also weighed on performance as the Fed signaled a gradual tapering to the simulative quantitative easing program. The emergence of coronavirus variants and associated increases in transmission rates also provided headwinds to equity markets. Capital goods, consumer cyclical, and communications names had the most significant negative effects on performance. The portfolio’s calculated duration is 2.0, with a yield of 3.0%.

Water Island

The Water Island Arbitrage and Event-Driven portfolio generated a net return of approximately -1.2%. Both strategy sleeves detracted from returns, with merger arbitrage accounting for about two-thirds of the loss and special situations for about one-third.

Deal Highlights

The top contributor in the portfolio for Q3 was a position in the attempted acquisition of Five9 by Zoom Video Communications. In July, Five9 – a US-based provider of cloud-based contact center software – agreed to be acquired by Zoom, the pandemic darling purveyor of cloud-based video conferencing software, for $15.7 billion in stock. After a disappointing earnings report during the quarter, Zoom’s shares – and thus the deal value – traded down nearly 30%. Arbitrageurs with a hedged position, however, not only were not impacted, but benefited, as the spread did not widen – it narrowed and eventually began trading negative, based on expectations that Five9 shareholders would agitate for a bump in terms to make up for the drop in deal value. (As of this writing in early October, the transaction was officially called off after Five9 shareholders voted not to approve the deal. While the companies had returned to the negotiating table, they were unable to come to terms before the shareholder vote. Water Island believes Zoom failed to offer a cash component, and many Five9 shareholders came to see Zoom stock as a less desirable asset following the poor earnings report. Despite the termination, the deal remains a contributor overall.) Other top contributors included the acquisitions of Maxim Integrated by Analog Devices and of Slack by Salesforce.com, both of which closed successfully, leading to gains for the portfolio.

The top detractor for Q3 was a position in the failed acquisition of Willis Towers Watson by Aon. In March 2020, Willis Towers Watson, a U.K.-based provider of insurance brokerage services, agreed to be acquired by Aon, a U.S.-based peer, for $30.3 billion in stock. The companies had already agreed to remedies with competition regulators in all required jurisdictions but one – the United States – when, following a second request from U.S. regulators, the DOJ sued to block the merger in June 2021. The DOJ raised antitrust concerns in five covered markets. The companies proposed additional remedies to cover three of the five business lines, with an additional divestiture potentially in play to address a fourth. Water Island believed the companies would go to trial to litigate concerns around the fifth market in an attempt to define it less broadly, however, in July, they jointly announced their intent to abandon the planned merger rather than go to court to defend against the attempted block by the DOJ. Ultimately, Water Island believed Willis Towers Watson felt their business was being hindered by the lengthy duration of the deal and the company did not want to wait any longer.

Upon the official break, the spread on this position traded through the team’s assessment of fair value on a standalone basis, as many event-driven investors sought to unwind their exposure at the same time. Water Island opted to maintain exposure and trade around the position rather than immediately exit, and while the position is still a detractor overall, they were able to take advantage of the dislocation and recover a meaningful portion of initial losses as the shares rebounded and new investors – including a band of activists – have gotten involved.

Other top detractors included the acquisitions of Change Healthcare by UnitedHealth Group and of Magnachip Semiconductor by Wise Road Capital, both of which are still pending. The Change Healthcare deal is being scrutinized closely by competition regulators, and the companies recently agreed to extend the deal timeline to give the DOJ additional time to conduct its review. Wise Road, a China-based private equity firm, encountered objections from the Committee on Foreign Investment in the United States (CFIUS) based on national security risks surrounding its deal to buy Magnachip, a South-Korea-based semiconductor manufacturer, despite the fact that CFIUS technically has no jurisdiction on this transaction. In response, the companies asked CFIUS for permission to withdraw and resubmit their filing (a relatively uncommon move in the CFIUS process, which was granted) in order to have an opportunity to mitigate the committee’s concerns. Water Island is monitoring both situations closely.

Water Island Market Commentary

After an admirable run of consistent, positive returns, the third quarter of 2021 marked the first meaningful stumbling block for event-driven strategies since the onset of the COVID-19 pandemic in Q1 2020. The weakness began at the tail end of Q2, when the DOJ sued to block the merger of insurance brokers Willis Towers Watson and Aon – a deal that had already acquired necessary regulatory approvals in all jurisdictions but the U.S. – in mid-June. At the time, the deal was one of the most widely held positions across event-driven portfolios, as it was a large, high-profile deal that most arbitrageurs believed had a strong likelihood of closing (despite indications the Biden administration would begin taking a more stringent antitrust view than has been typical for the U.S. in recent decades). In the ensuing weeks, arbitrageurs began assessing the merits of the DOJ’s case, potential remedies for the companies, and the probabilities of various outcomes. Much of the merger-arbitrage community came to the same conclusion we did: the companies had a strong case and would succeed in coming to an agreement with the DOJ or win in court. On July 26, however, the companies announced that they had mutually agreed to abandon their planned merger rather than proceed with litigation. This development sent shockwaves through the event-driven community, as losses in Willis Towers/Aon positions caused a cascading effect across the merger arbitrage universe, with forced de-risking amongst levered investors and further panicked selling not just in deals with antitrust risk, but across the landscape, driving spreads wider.

While the elevated volatility in our space was kicked off by antitrust concerns and the failure of Willis Towers/Aon, it was further fueled by additional risks – one novel, and one longstanding. Regulatory reviews in China have been a thorn in the side of arbitrageurs for several years now, as they are notably opaque and the Chinese government has demonstrated a willingness to wield the process as a tool in geopolitical relations. Despite the election of a new presidential administration in the U.S., relations with China remain frosty, leading to spread volatility in a handful of deals requiring Chinese approvals that have been pending longer than expected. More recently, we witnessed attempts by a cohort of retail investors to influence the share prices of companies using their stock as currency for pending acquisitions. With short interest in these acquirers elevated due to the hedges implemented by merger arbitrageurs, these retail investors believed the acquirers’ shares were rangebound and saw an opportunity to attempt to create a short squeeze – which they had famously done in other companies, such as GameStop, earlier in the year. Although these efforts have been largely unsuccessful longer-term, they did lead to a further increase in volatility for arbitrageurs short-term. Lastly, volatility in the broader markets spiked at multiple stages of the quarter, causing a reassessment of risk across a broad array of investors – traditional long-only, event-driven, and other strategies – simultaneously, which in turn led to more uncertainty, selling begat selling, and spread volatility continued.

In times like this, we believe it is important to remember that while the risks are real – deals can fail – in general, these are the same risks that have always existed in the strategy. If an arbitrageur understands the fundamentals of a deal, develops conviction in a position, and – importantly – can stomach volatility that may emerge along the way, once a transaction closes (and the vast majority of transactions do indeed close) the spread will narrow to zero. Broader market moves do not influence a deal’s likelihood of closing. Not only that, volatility can often present attractive entry points and opportunities to trade around spreads, potentially providing a boost to returns. With that in mind, while the portfolio’s quarterly return was negative overall, on a monthly basis the negative performance was limited to July. Amidst the volatility we capitalized on opportunities to trade around spreads and increase exposure to our highest conviction positions, which benefited the portfolio as the arbitrage universe began to steady itself and spreads narrowed over the final two months of Q3.

The spread environment began to recover after arbitrageurs were encouraged by the successful completion of a few high-profile transactions, most notably the acquisition of Maxim Integrated by Analog Devices (which required approval in China) and the acquisition of Slack by salesforce.com (which was feared to be a target of the Biden administration’s mistrust of consolidation amongst “big tech” companies). While we believe we are still in a phase of spread adjustment, current spreads remain attractive. We are well aware of the prevailing risks in this environment, but we have decades of experience navigating changing regulatory environments. We welcome volatility, deal flow remains plentiful, and as deals continue to close, dry powder will be freed up and capital can be put back to work at favorable rates of return. All told, we believe the final months of the year could be opportune for the strategy.

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 September 30, 2021

Blackstone Credit (DCI) Long-Short Credit Strategy

CDS Portfolio Statistics:

CDS Portfolio Statistics:	Long	Short
Number of Issuers	72	63
Average Credit Duration (yrs.)	4.9	5.0
Spread	143 bps	135 bps

DoubleLine Opportunistic Income Strategy

Sector Exposures as of 9/30/21
Cash	4.0%
Government	6.5%
Agency Inverse Interest-Only	10.4%
Agency CMO	0.4%
Agency PO	0.4%
Collateralized Loan Obligations	10.0%
Commercial MBS	12.7%
ABS	5.8%
Bank Loan	6.8%
Emerging Markets	5.8%
Non-Agency Residential MBS	33.5%
Other	3.7%
Total	100.0%

FPA Contrarian Opportunity Strategy

Asset Class Exposures as of 9/30/21
U.S. Stocks	47.2%
Foreign Stocks	25.9%
Bonds	1.8%
Limited Partnerships	0.9%
Short Sales	-1.6%
Cash	25.8%
Total	100.0%

Loomis Sayles Absolute Return Fixed-Income Strategy

	Long Total	Short Total	Net Exposure
Securitized	28.8%	-0.2%	28.6%
High-Yield Corporate	19.7%	-5.6%	14.2%
Investment-Grade Corp.	14.6%	0.0%	14.6%
Dividend Equity	11.0%	-0.3%	10.7%
Emerging Market	9.3%	-1.9%	7.4%
Convertibles	6.9%	0.0%	6.9%
Global Rates	1.8%	-0.2%	1.6%
Bank Loans	1.2%	-0.2%	1.0%
Global Credit	0.4%	-0.3%	0.1%
Subtotal	93.8%	-8.7%	85.1%
Cash & Equivalents	6.2%	0.0%	6.2%

Water Island Arbitrage and Event-Driven Strategy

Sub-Strategy Exposures

	Long	Short	Net
Merger Arbitrage – Equity	90.8%	-31.5%	59.3%
Merger Arbitrage – Credit	1.2%	0.0%	1.2%
Total Merger-Related	92.0%	-31.5%	60.4%
Special Situations – Equity	1.6%	0.0%	1.6%
Special Situations – Credit	2.8%	0.0%	2.8%
Total Special-Situations	4.5%	0.0%	4.5%
Total	96.4%	-31.6%	64.8%