Alternative Strategies Fund 10-Year Anniversary Q&A
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
The iMGP Alternative Strategies Fund (Institutional Share Class) gained 0.32% in the fourth quarter of 2021. During the same period, the Morningstar Multistrategy Category was up 1.45% and 3-month LIBOR returned 0.04%. For the full year of 2021, the fund gained 3.82%, compared to returns of 6.73% and 0.16% 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.
The fund produced a small gain during the quarter, as the underlying turbulence in parts of financial markets was hardly reflected in the returns of our subadvisors. The most significant return was fortunately a positive, with a 2.43% gain from FPA, while the other four managers were tightly clustered around flat performance. Given the US equity markets continued strength in the quarter, it isn’t surprising that FPA gained the most since they exhibit the highest beta and correlation to equities among our subadvisors. That said, holding dry powder and a portfolio of idiosyncratic positions including foreign-domiciled companies rather than one dominated by a narrow handful of tech/internet names (like the S&P 500 is) leaves FPA’s portfolio trailing in a period like Q4 where the index rises sharply. We are confident that over time, a portfolio containing more diversified drivers of return can produce strong absolute returns with less chance of sharp drawdowns when the market’s sentiment reverses and current winners become losers. We have seen some evidence of this already in an admittedly small sample size in calendar year 2022, as the S&P 500 Index is down almost 4% and the NASDAQ-100 Index is down almost 7% as of this writing, while FPA’s sleeve is slightly positive.
The discovery of the omicron variant of COVID-19 in late November was one clear and sizable speedbump during the generally positive quarter for risk assets, causing the VIX to spike by almost 66% during the month and November returns to stand out as an ugly exception. Markets digested the news and gains largely resumed in many assets, with VIX Index falling back to essentially the same level at year end as it was at the end of October. The larger and potentially longer-lasting events were the Fed’s announcements of its tapering of asset purchases at the November FOMC meeting, and the hawkish announcement of a faster pace of taper at the December meeting, setting the stage for faster than expected interest rate hikes in 2022. The subsequent release of the quite hawkish minutes from the December meeting also seemed to take the market by surprise, causing longer-duration assets to from Treasuries to growth stocks to suffer following the turn of the calendar.
The Fed is clearly in a challenging position, trying to tamp down stubbornly persistent inflation without kneecapping the economic recovery and financial markets. Overly tight monetary policy is typically one of the primary causes of a bear market, and with valuations near all-time highs, the risk of material stock market losses is high. Given how financialized the US economy has become and the wealth effect, the Fed seems to pay close attention and may reluctantly maintain the “Fed put” despite wanting to remove it. Might we see a replay of Q4 2018 where the Fed did a rapid about-face and eased monetary policy following a near bear market in response to higher rates? Or is maintaining credibility by stamping out inflation before inflation expectations become “un-anchored” a higher priority? We don’t know, and fortunately we aren’t forced to bet heavily one way or the other. In an easing scenario, the risk assets the fund owns should do well in absolute terms, although will likely trail higher-beta alternatives since the fund is relatively conservatively positioned. If rates continue to increase (with economic growth), the mix of low-duration, relatively high yielding credit positions the fund owns should do fine, the merger positions should be largely insulated, and the style-balanced equity exposure should be more defensive than growth-heavy broad market indexes. Differentiation in credits between winners and losers in such a marked shift should also help the Blackstone Systematic Credit portfolio. In this scenario, the fund may experience some short-term volatility, but we expect relative performance to be quite strong. Further, any meaningful market dislocations would present opportunities for managers to invest at more attractive valuations/spreads, setting the stage for potential future gains.
Widespread opportunities for valuation-conscious, risk-averse managers have been largely absent in the quarters following the initial recovery from March 2020’s pandemic-driven meltdown. That is not to say there has been nothing to do, as our long-biased credit subadvisors’ portfolios average a yield of almost 5% with a duration under 3. But an expanded menu from which to choose is a welcome development for managers with dry powder, flexibility, and experience.
|iMGP Alternative Strategies Fund Risk/Return Statistics 12/31/2021||MASFX|| Bloomberg|
|HFRX Global Hedge Fund||Russell 1000|
|Total Cumulative Return||61.9||34.6||39.1||28.4||417.0|
|Annualized Std. Deviation||4.6||3.0||4.2||4.2||13.5|
|Sharpe Ratio (Annualized)||0.9||0.8||0.6||0.5||1.2|
|Beta (to Russell 1000)||0.3||0||0.3||0.3||1.0|
|Correlation of MASFX to…||1||0.1||0.9||0.9||0.8|
|Worst 12-Month Return||-5.4||-2.5||-5.7||-8.2||-8.0|
|% Positive 12-Month Periods||86.6%||74.1%||78.6%||72.3%||94.6%|
|Upside Capture (vs. Russell 1000)||27.9||7.7||25.5||22.2||100.0|
|Downside Capture (vs. Russell 1000)||26.8||-7.4||34.6||33.6||100.0|
|Upside Capture (vs. AGG)||84.9||100||69.7||48.9||241.8|
|Downside Capture (vs. AGG)||-1.1||100||23.9||10.0||-108.1|
| Since inception (9/30/11).|
Worst Drawdown based on weekly returns
Past performance is no guarantee of future results
For the quarter, two sub-advisors produced positive returns, with FPA’s Contrarian Opportunity strategy up 2.43% and DoubleLine’s Opportunistic Income strategy gaining 0.22%. Three sub-advisors produced slightly negative returns: DCI’s Long-Short Credit strategy lost 0.08%, the Water Island Arbitrage and Event-Driven strategy declined by 0.12%, and the Loomis Sayles Absolute Return strategy was down 0.17%. (All returns are net of the management fee charged to the fund.)
The Long-Short Systematic Credit portfolio returned approximately -0.1% in Q4 2021, treading water amidst large market gyrations.
Credit selection advanced during the quarter, and as a welcome development the CDS sleeve delivered about 22 bps of positive performance after a generally down year. The bond sleeve again generated small alpha on the back of credit selection. The offsetting effects in the portfolio were from rates as the front end of the curve moved higher, producing a minor drag from the small residual duration in the portfolio, and from credit hedging as derivatives outperformed cash bonds a bit. The betas remain well-controlled, and the hedging has consistently delivered stability this year in the face of the increasing volatility in both rates and credit betas. The uplift in credit selection drivers suggests the environment is increasingly supportive of convergence, as the Portfolio Managers continue to expect credit fundamentals to re-assert themselves going forward.
In Q4 the portfolio selection returns were generally a modest positive. In CDS, gains were led by positive selection in Consumer and Insurance, with offsetting losses from Materials and Transports. In the bond sleeve, the portfolio performed well with selection in the Energy sector, which saw an uplift on the quarter, and was negative in Materials and Telecom. Steel makers were a headwind.
Reopening positioning has been balanced and the risk spend focused on idiosyncratic names. The portfolio is long Energy and short in Materials and Transports. This balance is somewhat comforting as Covid-uncertainty remains elevated. The portfolio has continued to emphasize idiosyncratic selection, with limited sector risk, although the model still sees further opportunities among Energy names due to the improving conditions generally, wide dispersion of fundamentals, and the tailwind of a steady rise in oil prices.
For the quarter the DoubleLine Opportunistic Income portfolio’s 0.2% gain outperformed the Bloomberg US Aggregate Bond Index flat performance. The outperformance was primarily driven by asset allocation as the various credit sectors in the Fund outperformed both the government-backed and corporate-backed assets held in the Index.
The two most noteworthy market developments during this period were the hawkish pivot from the Federal Reserve and the emergence of the Omicron variant of COVID-19. Firstly, in response to consistently high inflation readings, the Federal Reserve adopted more hawkish monetary policy in the form of tapering their monthly asset purchases. Shortly thereafter, the Omicron variant of COVID-19 began to grip markets as this new and highly contagious viral strain caused case counts to rapidly increase. The portfolio handled both of these obstacles quite well, with almost every sector generating positive returns over the quarter. The largest contributors to performance were non-Agency RMBS, ABS, and CLOs. The non-Agency RMBS benefitted from an especially strong US housing market while the ABS returns were propelled by strong cash flows from consumer-related and aviation-related investments. The CLO allocation naturally performed well as its coupons are indexed to short term interest rates and the Federal Reserve signaled multiple rate hikes were on the table for the 2022 calendar year.
Sectors that detracted from performance were Agency MBS and emerging market debt. The Agency MBS holdings experienced some duration-related price declines as 2-year and 5-year US Treasury yields rose 46 bps and 30 bps, respectively. Emerging market investments were hindered by a rallying US Dollar and contagion fears in the Asian credit markets stemming from the highly publicized Evergrande bankruptcy. The portfolio ended the quarter with a duration of 3.1 and a yield of 6.0%.
The Contrarian Opportunity portfolio gained about 2.4% during the quarter. The top contributors for the quarter were led by technology hardware companies, with Broadcom (+0.9%) and TE Connectivity (0.5%) topping the gainers, while Alphabet (0.5%), luxury goods company CIE Richemont (0.4%), and commercial truck dealer Rush Enterprises (0.3%) were also positive contributors. The largest detractors for the quarter included both cable companies Comcast (-0.3%) and Charter Communications (-0.3%), Citigroup (-0.3%), the Softbank/Softbank Group pair trade (-0.2%), and a hedge in the S&P 500 ETF (-0.2%).
Investment activity focused on the consumer/technology space, largely taking advantage of price weakness. New positions included Netflix and Uber, while FPA increased position sizes in Amazon, Activision, and Open Text. The PMs sold out of Meggitt following the announcement of its sale in Q3, Booking Holdings, and Olympus. They also closed out fixed income positions in Royal Caribbean, which was bought in the immediate aftermath of the start of the pandemic at a very attractive yield, and the Western Digital long term loan/short bond pair trade.
Gross long and net equity exposures remained consistent at approximately 73% and 72%, respectively. The largest sector concentration is in Communication Services, with Financials and Information Technology following. These three sectors comprise almost two-thirds of the equity portfolio. About one-third of the equity portfolio is in foreign stocks, as the portfolio managers continue to find attractive opportunities outside the US. Credit remains a tiny exposure, at about 1%, given meager yields and poor investor protections. Cash makes up approximately 26% of the portfolio, and represents increasingly valuable optionality to take advantage of any market dislocation in an environment of still-high valuations and a notably more hawkish Fed.
The Absolute Return strategy was down slightly during the quarter, declining by 0.2%. Despite accelerating inflation during the fourth quarter, improved labor market dynamics and strong consumer spending supported equity markets and the portfolio’s equity allocation generated gains. Technology, consumer non-cyclical, and financial names were the biggest contributors. High yield corporate bond spreads tightened marginally during the fourth quarter. As realized inflation surpassed targets, causing the Fed to provide guidance for tapering, high yield benefitted from a lower duration and maturity profile relative to investment grade credit. The portfolio’s financial and consumer issues were responsible for most of the sector’s positive performance.
Emerging market assets faced headwinds caused by continued US dollar strength and the persistence of the coronavirus, namely in the form of the emergent omicron variant. The expectation for the increased pace of tighter monetary policy was responsible for the stronger dollar, with the Fed expected to tighten policy more quickly than global central bank counterparts. Emerging markets assets detracted from the portfolio’s performance, with Chinese exposure being primarily responsible, despite being a small allocation.
Global rates tools, primarily sovereign bonds and interest rate futures, detracted from performance. The yields of the benchmark 10-year US and 30-year US Treasury experienced volatility during the quarter as result of elevated inflation and the Fed pivot, ranging from 1.34%-1.70% and 1.67%-2.16%, respectively. The portfolio’s short exposure to US Treasury futures was responsible for the majority of the allocation’s negative performance, concentrated in mid-October through November as yields fell significantly before reversing course somewhat in December. The portfolio’s calculated duration is 1.9, with a yield of 3.9%.
The Water Island Arbitrage and Event-Driven portfolio generated a very slight net loss (-0.1%) in the quarter. Merger arbitrage generated a gross positive return of about 0.6% while special situations lost about 0.4%.
The top contributor in the portfolio for Q4 was a position in the bidding war for RR Donnelley & Sons. RR Donnelley is a US-based provider of printing and related services to publishing, financial, merchandising, and other industries. In October 2021, the company reached an agreement with Chatham Asset Management, a US-based investment advisory firm, whereby Chatham would acquire the remaining 85% stake of RR Donnelley it did not already own for $464 million in cash. RR Donnelley subsequently received competing bids from private equity firm Atlas Holdings and an undisclosed interloper, spurring Chatham to increase its offer no fewer than four times. The bidding war has led to gains for the fund, though this situation has yet to be finalized. With Chatham’s latest bid standing as RR Donnelley’s currently preferred offer, Water Island is maintaining exposure and monitoring the situation closely. Other top contributors included two additional competing bid scenarios: railroad company Kansas City Southern, which once again agreed to terms with original acquirer Canadian Pacific Railway after a topping bid from Canadian National Railway encountered regulatory objections, and industrial REIT Monmouth Real Estate Investment Corporation, which was acquired by Industrial Logistics Properties Trust after shareholders rejected an offer from Equity Commonwealth.
The top detractor in the portfolio for Q4 was the position in Zoom Video Communications’ failed attempt to acquire Five9 – largely due to the timing of the calendar. 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. This position was the portfolio’s top contributor during Q3 as investors sent the spread into negative territory, believing Zoom – after seeing its share price drop following a poor earnings report – would be forced to increase its offer to secure support from Five9 shareholders. While the companies had returned to the negotiating table, they were ultimately unable to come to terms and on the night of the final day of Q3 they announced the transaction had been terminated. This led to losses at the start of Q4 stemming from the deal break, however the position was flat overall due to the positive performance during Q3. Other top detractors included a position in insurance giant Willis Towers Watson, which Water Island continues to unwind on strength following the termination of its acquisition by peer Aon due to regulatory objections, and a position in the merger of semiconductor companies Xilinx and Advanced Micro Devices, which once again pushed back the expected timing for deal completion due to continued delays in the regulatory approval process in China.
Water Island Market Commentary
The failure of the attempted combination of Willis Towers Watson and Aon has led to interesting knock-on effects through the merger arbitrage community. Typically, good news in the merger arbitrage space begets more good news. If a deal that had been facing regulatory tensions successfully closes or receives an approval, arbitrageurs – having gained a better sense of that regulator’s current attitude toward antitrust – see it as an opportunity to put money to work in other deals in similar situations. After the Willis Towers break, however, we have seen most good news met with selling – an opportunity to take profits, rather than increase exposure. For those merger arbitrage portfolios that held large positions in Willis Towers/Aon, it seems the risk managers stepped in to navigate the remainder of the year. Thus, several large transactions that are still pending due to lengthy regulatory reviews saw their spreads idle in the latter months of the year. At the same time, we have seen investors respond to reports with even a hint of negativity in other transactions by rushing to the exit, leading to plenty of spread volatility. We often see opportunity in these situations – advantageous entry points where we can put dry powder to work – though in the current environment, it may take more patience to reap the results.
Frosty US/China relations continue to put a damper on the regulatory review process in China, where the State Administration for Market Regulation (SAMR) – China’s primary competition regulator – is notoriously a black box. Spreads in transactions requiring SAMR approval have been highly volatile, and some deals have experienced significant delays waiting for China approval.
Turning back to the US, market volatility has been widespread. Certain sectors, such as technology, have experienced fleeting but more frequent pullbacks in recent months, which could lead to opportunistic M&A activity in these areas. At the same time, we believe the risk of a broader, more meaningful market downturn is increasing, which may require more caution when investing in stock-for-stock deals where a shareholder vote is required at the acquirer. That said, disruptions in valuations have historically opened the window for competing bids. Indeed, topping bids were a theme from the latter half of 2020 into early 2021, and we are still seeing bidding wars being contested for valuable assets. While the frequency of topping bids slowed in the latter half of 2021 relative to the first half of the year, their magnitude was more impactful.
Historically, increases in the risk-free rate have acted as a tailwind for merger arbitrage returns. Given the Federal Reserve’s decidedly hawkish turn at its most recent meeting, consensus generally expects multiple rate hikes in the coming year. While we believe the historical relationship between rates and merger arb returns will continue, it’s important to note the risk if rates rise too high, too fast. A mere 25 basis point increase in interest rates could require 10% revenue growth for a company to maintain the same valuation. While the parties to a merger are baking in certain assumptions around rates to their valuations, if rates don’t move in line with these expectations, we could see an increase in incidents of buyer’s remorse. To mitigate this risk, we may avoid transactions in industries that are more impacted by rates (e.g., utilities) and seek out deals that don’t require an acquirer shareholder vote or in industries that benefit from rising rates (e.g., banking).
By most metrics, the past year set records for M&A activity worldwide. In the US alone, more than $2.5 trillion worth of deals were inked, surpassing the prior record of $2.0 trillion in 2015, according to Bloomberg data. Deal flow was broad-based as well, with more than 20,000 transactions – another record overall, with additional records set in individual sectors. The activity shows no sign of subsiding in the near term. Corporate balance sheets are generally healthy, and private equity firms – who have been becoming increasingly reliable buyers, potentially shedding past reputations – remain flush with cash. Furthermore, financing is readily available at interest rates which are currently at historic lows, and would still be extremely attractive should any impending rate hikes from the Fed remain modest.
With robust M&A activity continuing, we are seeing opportunities in newly announced deals that seem to be flying under the radar. We haven’t been witnessing the typical day-one spread movements that we’ve experienced in the past, and we believe many arbitrageurs who run concentrated books may still have their attention directed toward legacy positions in large, still-pending deals burdened with unexpectedly lengthy regulatory reviews. As those deals close over the coming months, capital should be redeployed into these new transactions, driving their spreads tighter. Yet while we are optimistic for the months ahead, by no means do we believe global regulators are done attempting to enforce their evolving attitudes toward antitrust. In the US in particular, certain types of transactions seem likely to face difficulty from the get-go – for example, big tech mergers, any combination of banks with more than $100 billion in deposits, or consolidation amongst utility companies that fails to create a new corporate structure highlighting green energy. In an environment where global supply chains have been disrupted by the pandemic and where scaling up by buying competitors may be discouraged, we could instead see more companies seek to engage in vertical mergers and bring supply chain expertise in house. Regardless of the specific complexion of future M&A, as always, we remain prepared to capitalize on the opportunities that present themselves, while maintaining a keen eye toward risk mitigation and downside protection.
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.
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top 5 Sector Long Exposures as of 12/31/21|
CDS Portfolio Statistics:
|CDS Portfolio Statistics:||Long||Short|
|Number of Issuers||77||70|
|Average Credit Duration (yrs.)||4.6||4.7|
|Spread||143 bps||135 bps|
DoubleLine Opportunistic Income Strategy
|Sector Exposures as of 12/31/21|
|Agency Inverse Interest-Only||9.7%|
|Collateralized Loan Obligations||9.4%|
|Non-Agency Residential MBS||33.4%|
FPA Contrarian Opportunity Strategy
|Asset Class Exposures as of 12/31/21|
Loomis Sayles Absolute Return Fixed-Income Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||6.7%||0.0%||6.7%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||94.9%||-18.9%||76.1%|
|Merger Arbitrage – Credit||0.0%||0.0%||0.0%|
|Special Situations – Equity||1.3%||0.0%||1.3%|
|Special Situations – Credit||2.7%||-0.1%||2.6%|
To commemorate the anniversary, co-Portfolio Managers Jeremy DeGroot and Jason Steuerwalt have penned a Q&A retrospective on the fund and the category at large. MORE
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Although the managers actively manage risk to reduce portfolio volatility, there is no guarantee that the fund will always maintain its targeted risk level, especially over shorter time periods and loss of principal is possible. The performance goals are not guaranteed, are subject to change, and should not be considered a predictor of investment return. All investments involve the risk of loss and no measure of performance is guaranteed. The fund aims to deliver its return over a full market cycle, which is likely to include periods of both up and down markets.
Though not an international fund, the fund may invest in foreign securities. Investing in foreign securities exposes investors to economic, political and market risks, and fluctuations in foreign currencies. Investments in debt securities typically decrease when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in mortgage-backed securities include additional risks that investor should be aware of including credit risk, prepayment risk, possible illiquidity, and default, as well as increased susceptibility to adverse economic developments. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Multi-investment management styles may lead to higher transaction expenses compared to single investment management styles. Outcomes depend on the skill of the sub-advisors and advisor and the allocation of assets amongst them. Investing in derivatives could lose more than the amount invested. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Merger arbitrage investments risk loss if a proposed reorganization in which the fund invests is renegotiated or terminated.
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Alpha is an annualized return measure of how much better or worse a fund’s performance is relative to an index of funds in the same category, after allowing for differences in risk.
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As of December 31, 2021 the PartnerSelect Alternative Strategies Fund’s top 10 holdings were:
|IHS MARKIT LTD||1.37%|
|WILLIS TOWERS WATSON PLC||1.22%|
|NUANCE COMMUNICATIONS INC||1.04%|
|CHANGE HEALTHCARE INC||0.77%|
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