The iMGP Alternative Strategies Fund (Institutional Share Class), formerly known as Litman Gregory Masters Alternative Strategies Fund, gained 7.64% in the second quarter of 2020. During the same period, the Morningstar Multialternative category was up 4.67%, and 3-month LIBOR returned 0.44%. Year to date through June 30, the fund is down 2.43% while the category is down 5.44% and 3-month LIBOR is up 0.94%.
Past performance does not guarantee future results. Index performance is not illustrative of fund performance. An investment cannot be made directly in an index. Short-term performance in particular is not a good indication of the fund’s future performance, and an investment should not be made based solely on returns.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 fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit www.partnerselectfunds.com. Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.
The Alternative Strategies Fund produced a strong return of 7.64% during the quarter, recovering most of the loss from the first quarter. We wrote in our last update that we looked forward to reporting better results to fellow shareholders in the future, which we are pleased to do this quarter. It was gratifying to see some of what we discussed playing out in terms of our sub-advisors relying on their experience in past crises and taking advantage of market dislocations to increase exposures to attractive opportunities.
Loomis Sayles is the most striking example of this. They greatly reduced hedges and increased exposure to corporate credit (as well as some structured credit) during the depths of the fear and market panic in March, as they recognized the “bazooka” of monetary and fiscal stimulus backstopping the U.S. credit market, in the short term at least. Water Island was also a standout in that regard, adding to the positions they felt had the strongest merger agreements at extraordinary annualized spreads, producing excellent returns for the quarter as the environment normalized somewhat. Water Island is the top-performing sub-advisor for the fund year to date through the second quarter with a gain of 3.84%.
DoubleLine and Loomis Sayles both still offer very attractive mid- to high-single-digit yields on their portfolios even after their performance rebound in the second quarter. This is partially from having gotten noticeably more aggressive (more applicable to Loomis Sayles) and partially from owning assets that haven’t been the direct target of Federal Reserve/Treasury support programs and thus haven’t recovered as sharply (more applicable to DoubleLine). The result is a large portion of the portfolio that produces an attractive yield with additional capital appreciation potential as well for significant areas.
DCI held up extremely well during the downturn and is slightly positive for the year but was hurt by the nearly indiscriminate credit rally in the second quarter. However, the credit spread environment is still good relative to the extremely tight levels prior to the pandemic. Going forward, an increased differentiation between improving and deteriorating credits, following the liquidity-driven rally, should provide a good environment for the DCI strategy.
While we are concerned about the fundamental health of the economy given still-high unemployment and the increase in new cases of COVID-19 in several parts of the country, we are optimistic about the fund’s prospects for continued good performance from here.
|iMGP Alternative Strategies Fund Risk/Return Statistics 12/31/20||MASFX|| Bloomberg|
|HFRX Global Hedge Fund||Russell 1000|
|Total Cumulative Return||55.98||36.67||18.25||23.84||308.83|
|Annualized Std. Deviation||4.71||2.95||4.48||4.35||13.82|
|Sharpe Ratio (Annualized)||0.90||0.95||0.28||0.40||1.18|
|Beta (to Russell 1000)||0.29||0.00||0.30||0.27||1.00|
|Correlation of MASFX to…||1.00||-0.07||0.83||0.68||0.80|
|Worst 12-Month Return||-5.36||-2.47||-6.65||-8.19||-8.03|
|% Positive 12-Month Periods||85.44%||80.58%||70.87%||69.90%||94.17%|
|Upside Capture (vs. Russell 1000)||29.21||8.81||22.53||22.78||100.00|
|Downside Capture (vs. Russell 1000)||27.12||-9.13||37.90||34.05||100.00|
| Since inception (9/30/11).|
Worst Drawdown based on weekly returns
Past performance is no guarantee of future results
Performance of Managers
For the quarter, all five sub-advisors produced positive returns. FPA’s Contrarian Opportunity strategy was up 13.67%, the Loomis Sayles Absolute Return strategy was up 10.12%, DoubleLine’s Opportunistic Income strategy gained 6.92%, Water Island’s Arbitrage and Event-Driven strategy returned 6.52%, and the DCI Long-Short Credit strategy increased by 2.12%. (All returns are net of the management fee charged to the fund.)
Key Performance Drivers and Positioning by Strategy
The DCI Long-Short Credit strategy returned 2.12% in the second quarter and is now in positive territory for the year. The credit default swap (CDS) sleeve was a modest positive contributor, while the bond sleeve powered ahead, driven by the furious market rally. Net beta effects were a positive contributor, as rates were a small positive and cash bonds outperformed the derivative hedges. The cash bond gains versus hedges were a catch-up for some underperformance going back to the end of March. By design the portfolio construction is always focused on asset selection—favoring firms with lower default risk (as measured by DCI’s proprietary default probability model) and improving fundamentals—and is constructed with neutral credit beta. While market dislocations eased significantly over the quarter, DCI still sees elevated spread dispersions and heightened credit differentiation and opportunity, which should be a positive factor for the strategy going forward.
Investment-grade corporate bonds continued to deliver strong outperformance in the United States and Europe, outgaining high-yield on a risk-adjusted basis. Credit curves continued to normalize, with shorter-dated bonds benefiting from the Fed’s focus on that part of the curve, but remain flat by historical levels indicating that more steepening may be in order. Other measures of market health, like the bond-CDS basis (the difference in yield between a company’s bonds and the corresponding CDS) and spread dispersion, have eased further from April but, likewise, remain elevated. High-yield firms, particularly in the energy sector, continued to face default pressures and high-profile bankruptcies have now become the norm. The current high-yield CDX index (launched in mid-March) has already set the record for defaults with seven, and the next roll is not until September. There were two more defaults in June, California Resources and Chesapeake Energy both went bankrupt, as the dominoes continued to fall among shale producers.
Security-selection alpha in the DCI portfolio overall treaded water during the quarter, as losses in bond selection offset the gains in CDS. Both sleeves struggled beginning in late May as the furious market rally drove an outsized recovery in low-quality credits that disproportionally hurt the short-side of the portfolio and long quality credits could not keep pace. In CDS, long positions in media and consumer goods led the way, outpacing losses in short financials and retail names. In bonds, the portfolio had been underweight in energy and that led to negative selection as it missed out on some of the bounce back rally that was led by high-spread, distressed energy names.
Positioning rotated significantly over the quarter, with a notable move from short to long in energy and in media, and from long to short in consumer goods and industrials. The strategy remains long tech and housing, and short financials, and still sees attractive short positions in many retailers. As always, the credit selection portfolio favors improving fundamentals and strong credit quality.
For the quarter, the DoubleLine Opportunistic Income portfolio gained 6.92%, outperforming the Bloomberg Barclays U.S. Aggregate Bond Index (Agg Index) return of 2.90%. The main driver of outperformance was asset allocation as the portfolio maintained a roughly 80% allocation to credit-related assets while the Agg Index was consistently only about 30% credit assets. In the wake of the March 2020 selloff, many credit sectors—both secured and unsecured—enjoyed strong rallies as liquidity conditions improved and risk appetite returned to the market.
The largest contributors to returns within the portfolio were collateralized loan obligations (CLOs), emerging-market (EM) corporate bonds, and non-agency residential mortgage-backed securities (RMBS). CLOs experienced significant spread rallies during May and June due to their relatedness to U.S. corporate bonds. When the Fed announced its open support for corporate debt via the Secondary Market Corporate Credit Facility (SMCCF), CLO returns began to improve because investors expected the effects of that program to trickle into the underlying bank loan market as well. As for EM debt, returns during the quarter were mainly bolstered by increasing crude oil prices and general weakness in the U.S. dollar. Lastly, the non-agency RMBS within the portfolio generated strong returns in the later stages of the quarter because overall forbearance activity in the U.S. mortgage market has broadly come in below original expectations.
The only sector to detract from performance was asset-backed securities (ABS). The ABS holdings within the portfolio are primarily made up of student loan securitizations and securitizations of leased midlife aircrafts. These two sectors have been especially hard hit by the COVID-19 pandemic as deferment and forbearance activity have been somewhat elevated for these borrower bases. The strategy ended the quarter with a duration of approximately 2.2 and a yield to maturity of 6.1%.
The FPA Contrarian Opportunity portfolio delivered a solid rebound (up 13.67%), although it remains down 10.32% year to date. New positions throughout the quarter include Otis Worldwide (as a result of the merger between United Technologies and Raytheon) and new fixed-income positions in Carnival and Royal Caribbean Cruises, which both issued new secured bonds at double-digit yields to improve their liquidity positions in response to the pandemic-driven shutdown of cruises. During the quarter, FPA sold out of several positions, including Air Canada, Dupont de Nemours, JD.com, and Royal Bank of Scotland. Several short positions were also eliminated, including some components of the autos pair trade (Honda Motor Co., Peugeot, and Renault).
Top contributors for the quarter were Analog Devices, Broadcom, Facebook, American International Group, and TE Connectivity. The largest detractors were a debt position in oilfield services company BJ Services, GACP II (private credit), Tesla (a very small but painful short position), Wells Fargo, and the short hedge position in the Financial Select Sector SPDR Fund.
Gross long exposure to equities is 72.5% and net exposure is approximately 70.7%. Gross long credit is 8.2% and net exposure is approximately 7.3%. Cash has been reduced to 20.9%, as U.S. equity exposure increased by over five percentage points during the quarter, international equity exposure increased by over three points, and credit increased by over two points. The portfolio managers intend to manage the portfolio in a more fully invested manner (although still with significant dry powder), partially due to the drastically increased fiscal and monetary stimulus that has made holding cash so punitive.
The largest sector exposure is in communication services (which includes high-quality tech names like Alphabet as well as cable companies like Comcast) at about 21% of the portfolio, with financials (16%), and information technology (12%) following. These three sectors comprise well over half of the equity component of the portfolio. Despite the tightening of credit spreads since late March, FPA continues to expect stress in the high-yield market as fundamentals remain challenged for many industries, which should produce attractive opportunities going forward.
The Loomis Sayles Absolute Return strategy benefited from the portfolio managers’ fairly aggressive repositioning during the credit market meltdown in the first quarter, gaining 10.12% in the second quarter and moving back into positive territory on the year.
High-yield corporate bonds (and the high-yield CDX index) performed well during the period as spreads meaningfully tightened. The sector gave back some ground in June as media coverage centering on an increase in coronavirus cases raised doubts about the pace of economic growth.
Within the portfolio, consumer, basic industry, and communications issues buoyed performance. High-yield was the largest increase in exposure in March and continues to be the largest exposure in the portfolio at almost 50% net (including cash bonds and CDX). The portfolio managers believe current spreads offer good compensation for risk, considering the Fed, Treasury, and Congress’s ultra-aggressive stimulus and support of credit markets. However, they recognize the need for caution and selectivity, given the continued higher-volatility regime driven by questions related to the scale and fallout of COVID-19, trade policy, election outcomes, and rate volatility.
Investment-grade corporate bonds performed well as supportive policy from governments and central banks in Europe and the United States has driven spreads significantly tighter. Policymakers have demonstrated the willingness to go to great lengths to support market stability in an effort to counteract the adverse economic impacts of the virus. For the portfolio, investment-grade corporates contributed strongly to performance, with energy, consumer cyclical, and technology names being particularly beneficial. Securitized assets also added to performance. The sector generally benefited from improved consumer and business outlooks, rebounding from the fear that disrupted markets in the first quarter. Allocations to non-agency RMBS, CLOs, and ABS issues had the largest positive impacts on the portfolio’s performance within the securitized book. Commercial mortgage-backed securities (CMBS) issues marginally detracted due to exposure to commercial industries most impacted by the dislocation. The portfolio’s yield to maturity is over 7%, with a duration of about 3.5.
The Water Island Arbitrage and Event-Driven portfolio generated a return of 6.52% during the quarter. Both strategy sleeves contributed to returns: +605 bps (gross) from merger arbitrage (+560 bps from equity-based merger arbitrage and +46 bps from credit-based merger arbitrage) and +74 bps from special situations (+62 bps from equity special situations and +12 bps from credit special situations). The portfolio remained heavily weighted toward merger arbitrage, but the allocation to special situations increased materially, ending the quarter at 82% merger arb and 11% special situations (based on gross long exposure).
The top contributor in the portfolio for the second quarter was a merger-arbitrage position in the acquisition of Caesars Entertainment by Eldorado Resorts. In June 2019, Eldorado Resorts, a U.S.-based holding company for casino hotels, agreed to acquire Caesars Entertainment, a local peer, for $10.0 billion in cash and stock. During first quarter, casinos across the nation were forced to shutter due to the novel coronavirus outbreak, causing the share prices of casino operators to plummet. This led many investors to question the desire of Caesars and Eldorado to consummate their transaction, sending the deal spread wider. In Water Island’s analysis, the merger agreement and the strategic rationale for the transaction remained strong, and with the financing for the deal already committed, the team believed there was still a high likelihood of reaching a successful conclusion. The volatility in the deal spread allowed the portfolio managers to increase the position at favorable rates of return. The portfolio benefited from a tightening in the deal spread as the market rallied in April and May, casino operator stock prices began to recover, and the deal progressed through the regulatory approval process. Water Island anticipates the deal will close in the early part of the third quarter after the receipt of all required regulatory approvals. Other top contributors included merger-arbitrage positions in the acquisition of Tallgrass Energy by a private equity consortium led by Blackstone and the merger of pharmaceutical companies AbbVie and Allergan. The spread on the Tallgrass/Blackstone deal widened significantly in the first quarter due to fears the buyers would attempt to abandon the transaction amidst the emergence of an oil price war between Russia and Saudi Arabia and the severe market dislocation. The buyers, however, publicly stated they remained committed to the deal and Tallgrass shareholders voted to approve the transaction in April. The deal successfully closed shortly thereafter, leading to gains in the portfolio. AbbVie and Allergan announced their $85 billion merger in June 2019, and the original expectation was for an early 2020 close. A slight delay in the regulatory approval process was further exacerbated by the pandemic. The deal ultimately closed in May 2020, leading to gains in the portfolio. In each of the above situations, Water Island was able to benefit by scaling up exposure at favorable rates of return during the first quarter dislocation in spreads.
The top detractor in the portfolio for the second quarter was a merger-arbitrage position in Simon Property Group’s planned acquisition of Taubman Centers. In February 2020, Taubman Centers—a U.S.-based shopping center REIT—agreed to be acquired by local peer Simon Property Group for $3.2 billion in cash. As the COVID-19 pandemic spread and malls shuttered or saw their traffic plummet amidst mass quarantines, investors began to fear Simon Property may attempt to abandon the transaction and Taubman shares fell as much as 24% from their peak during the quarter. Water Island maintained exposure to the deal, believing the definitive merger agreement is one of the strongest contracts in the merger space today and that Simon has very few—if any—avenues to escape its obligation to complete the merger. In June, Simon filed to terminate the transaction, claiming Taubman has been disproportionately impacted by the pandemic and has breached its obligations under the merger agreement. Taubman in turn claimed Simon’s termination is invalid and without merit, and the company believes Simon continues to be bound to the transaction in all respects. Water Island’s conviction in the position has not wavered, and they believe Taubman by far has the stronger case for several reasons. The merger agreement excludes pandemics as reasons by which a material adverse change (MAC) may be claimed. Furthermore, Taubman’s obligations under the agreement only call for the company to exercise “commercially reasonable” efforts in conducting its ordinary course of business. There are no financing contingencies on this deal, and it is being funded solely from Simon’s balance sheet. The investment team has reviewed Simon’s court filing and they believe it makes what are at best dubious claims to support the company’s argument for termination (even more so as malls reopen and foot traffic resumes). Lastly, the case was filed in Michigan, where Taubman is both domiciled and headquartered. In Water Island’s experience through similar court cases and appraisal rights processes, a “home court” advantage in such proceedings is very much a real thing. Taubman is a highly strategic asset for Simon, and there is a chance the lawsuit is simply an attempt by Simon to convince Taubman to agree to a cut in deal terms to avoid lengthy, costly litigation—but if the case does go to trial, Water Island is confident that Taubman can emerge victorious and require Simon to complete the deal on its original terms.
While event-driven strategies are somewhat isolated from broader market volatility due to their idiosyncratic nature, it is hard to remain totally unaffected in an environment with extreme swings. This was evident in the first quarter, as widespread, forced, and panicked selling caused correlations to converge. Fortunately, Water Island was able to capitalize on dislocations and put dry powder to work at favorable rates of return, which helped drive the portfolio’s strong performance in the second quarter. However, they expect continued bouts of volatility in the months ahead.
Not only has the ultimate outcome of the COVID-19 pandemic yet to be written, but there remains the added wrinkle of a presidential election this year in the United States.
Merger-arbitrage returns could be challenged in the short term as interest rates are subdued, the pace of newly announced mergers and acquisitions (M&A) is likely to abate before it picks up again, and M&A targets and acquirers are more likely to attempt to abandon a definitive transaction during a time of economic distress and uncertainty. That said, the current slate of pending deals is providing plenty of opportunity and—as always—a definitive merger agreement is a binding contract. With few exceptions (such as a MAC in a company’s business or failure to secure financing, a shareholder vote, or regulatory approval for a deal) a definitive transaction, once announced, must close. The job of arbitrageurs is to discern which transactions are at greatest risk of incurring these exceptions—the deals to avoid—and which warrant adding to the portfolio.
Furthermore, despite potential headwinds for merger arb, Water Island sees reasons to be optimistic. Following a period in which asset prices have been depressed, after an initial slowdown in M&A, in their experience consolidation activity has resumed quickly. Companies in a position of strength seek to make opportunistic acquisitions while companies in a position of weakness must combine to survive. Competitive bidding situations can also come back quickly, as the team witnessed in 2009, coming out of the financial crisis.
Outside of the merger-arbitrage strategy, Water Island intends to remain focused on the types of catalysts that can best help isolate the portfolio from broader market moves (i.e., shorter-duration investments with more definitive outcomes). This includes a robust pipeline of spinoffs as well as speculative M&A opportunities in several transactions that were rumored to have been underway yet were called off in light of the pandemic, but which they now believe are more likely to resume. Regardless of the specific makeup of the portfolio—merger arbitrage or special situations, hard or soft catalyst—the portfolio managers will continue to maintain focus on risk management while seeking to generate returns from the outcomes of idiosyncratic corporate catalysts rather than broad market direction, striving to preserve capital during times of market stress.
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, 2020
DCI Long-Short Credit Strategy
|Bond Portfolio Top 5 Sector Long Exposures as of 12/31/20|
CDS Portfolio Statistics:
|CDS Portfolio Statistics:||Long||Short|
|Number of Issuers||87||77|
|Average Credit Duration (yrs.)||4.8||4.8|
|Spread||111 bps||115 bps|
DoubleLine Opportunistic Income Strategy
|Sector Exposures as of 12/31/20|
|Agency Inverse Floaters||1.5%|
|Agency Inverse Interest-Only||9.5%|
|Collateralized Loan Obligations||8.1%|
|Non-Agency Residential MBS||41.5%|
FPA Contrarian Opportunity Strategy
|Asset Class Exposures as of 12/31/20|
|Bonds and Loans||3.9%|
Loomis Sayles Absolute Return Fixed-Income Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||8.7%||0.0%||8.7%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||76.1%||-26.4%||49.7%|
|Merger Arbitrage – Credit||3.2%||-0.2%||3.0%|
|Special Situations – Equity||11.7%||-1.0%||10.7%|
|Special Situations – Credit||3.9%||0.0%||3.9%|