The iMGP Alternative Strategies Fund (Institutional Share Class) declined 5.60% in the second quarter of 2022. During the same period, the Morningstar Multistrategy Category was down 3.04% and the ICE BofA 3-Month Treasury Bill Index returned 0.10%. For the first half of the year, the fund was down 8.51%, compared to a loss of 10.35% for the Bloomberg US Aggregate Bond Index, a loss of 4.18% for the category and a 0.14% gain for the ICE BofA 3-Month Treasury Bill Index.
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.
For Q2, the Alternative Strategies Fund declined 5.6%, leaving returns for the year down about 8.5%. Without mincing words, this is disappointing to us, both as stewards of your capital as well as fellow shareholders. Part of our goal is preserving capital, while generating good absolute returns over a full market cycle. This recent absolute performance is short of what we would have hoped to deliver. But since the Fund’s inception, we have also been clear that shareholders could expect the fund to be down in the mid-single digits during an equity bear market. And we have seen that play out so far this year.
For context, and while you cannot invest in an index, a very conservative 20/80 stock/bond mix, was down 7.0% for the quarter (as measured using the Bloomberg Aggregate Bond Index -4.69%and S&P 500 Index -16.1%) and a stunning 12.2% (Bloomberg Aggregate -10.35% and S&P 500 -19.97%) for the year. We think this is relevant since this we know many Alternative Strategies Fund investors fund their allocation from some stock/bond mix in this ballpark range. And although the fund trailed the Agg slightly in Q2, it is still outperforming by nearly 200 basis points through the first half of the year (and roughly 13 percentage points cumulatively over the last two years).
We hesitate to use the word ‘unprecedented’ since it seems to be this year’s version of ‘transitory,’ but the simultaneous poor performance of nearly all asset classes (excluding commodities, which themselves have recently started to roll over) is striking. We point this out not to make excuses, but to provide context. We all recognize the main drivers, clear in retrospect: stubbornly high and persistent inflation, exacerbated by Russia’s war in Ukraine, which drove accelerated aggressive monetary tightening by the Fed. This in turn punished long-duration assets: bonds obviously, but also previous market leaders like dominant large cap growth stocks, which had been seen as relative safe havens compared to more cyclical assets, resulting in rich valuation multiples that have been crushed by higher discount rates and fear of slowing growth.
The virtuous cycle of Quantitative Easing is also reversing, draining liquidity from the system and tightening financial conditions when consumer confidence is already extremely low. Much of the financial market commentary and discussion now is of the other shoe dropping, whether it be a technical recession or “just” slowing growth accompanied by falling corporate profits, which would presumably result in further equity market losses. Losses in one or multiple areas of financial markets often drives selling in other parts, causing risk premia to widen even in areas not directly impacted, even including those with reasonably strong fundamentals, producing contagion. The chances of the Fed “threading the needle” and controlling inflation without significantly hurting the economy seem remote at this point. None of this is breaking news, of course, but negative headlines abound. However, without minimizing the challenges (and of course the related “real-world” pain), we think there is reason for cautious optimism.
There is a lot of bad news and negative sentiment already priced into financial markets. Things can always be worse than consensus expectations, and we fully recognize the Fed seems committed to breaking inflation, almost regardless of the cost to equity markets. However, we think the Alternative Strategies fund may well be set up to potentially produce attractive performance over the next multiple quarters or more going forward. (This is not to say that returns couldn’t decline further from here in the short or even medium term – they absolutely could.) In the past we have bristled at managers seemingly brushing off periods of weak performance and focusing only on the glorious outlook going forward, as if no one experienced the painful road traveled to arrive at the precipice of the promising future. That is absolutely not our intention, having acknowledged the challenges both in the fund’s performance and the economy and markets, we think it is worth maintaining some balance in perspective.
The fund’s portfolio has rarely been as attractive as it is currently, in our view. The credit strategies are yielding in the upper single digits on a blended basis (and have some dry powder in cash) with a blended duration under three years. The merger arbitrage portfolio offers an average annualized deal spread well into the teens after holding up relatively well during the difficult first half of the year. Deals can break, spreads can widen, and defaults can increase, but these levels have historically been very attractive entry points even if they don’t necessarily mark “the bottom” for returns, which is of course impossible to time with any precision. The long-short credit strategy has protected capital well through market turmoil, and its fundamental drivers now appear to be at their most attractive since late 2018/early 2019 (preceding the strategy’s strongest year of performance): credit spreads are wide, volatility is increasing, and there is wide dispersion in company fundamentals and default probabilities, which are still in the early stages of being fully reflected by the market. Lastly, FPA’s portfolio, the largest contributor to returns since inception but the most volatile and highly correlated with the equity market, has unsurprisingly been hit the hardest this year. Without going into detail here, we believe it is also attractive, with a mix of value and quality growth businesses at reasonable valuations, pockets of special situations, and the optionality of a healthy cash balance. Again, the FPA sleeve the most market-dependent, but is the smallest allocation within the fund. It also has the highest short-term upside in the event of positive surprises relative to market expectations.
We should also note that we are in the later innings of research and discussions about adding a new strategy to the fund and will very likely be able to announce something later this year. The strategy would have been extremely beneficial over the last two to four quarters, is not so geared to a particular environment that it would have detracted from the fund’s performance in other periods. It seeks to improve the fund’s risk-adjusted returns across different environments and reduce drawdowns like the current one. We have always tried to avoid overreacting to recent events (for example, we evaluated but didn’t add tail-risk strategies following March 2020, to the benefit of returns the rest of the year and in 2021), so we wouldn’t say this is a reaction to performance this year. However, strategies of this type have been the subject of our interest and research for several years, and 2022 certainly did nothing to temper our enthusiasm. We are excited about the prospects for the fund going forward, even more so as we envision it with the likely addition we have discussed.
Thank you for your investment in the fund. We look forward to updating you next quarter, hopefully with significantly better results.
iMGP Alternative Strategies Fund Risk/Return Statistics 6/30/2022
|Statistics of 6/30/2022||MASFX||Bloomberg US Agg Bond Index||Morningstar US Fund Multistrategy||Russell 1000 Index|
|Total Cumulative Return||48.15||20.64||33.27||308.70|
|Annualized Std Dev||4.72||3.41||4.25||14.15|
|Sharpe Ratio (Annualized)||0.67||0.35||0.50||0.96|
|Beta to Russell 1000||0.28||0.03||0.27||1.00|
|Correlation of MASFX to||1.00||0.26||0.91||0.84|
|Worst 12-Month Return||-8.78||-10.29||-5.71||-13.04|
|% Positive 12-Month Periods||0.83%||0.70%||0.78%||0.92%|
|Upside Capture vs Russell 1000||27.34||6.65||25.38||100.0|
|Downside Capture vs Russell 1000||27.74||0.04||31.45||100.0|
|Upside Capture vs Agg||83.64||100.0||69.24||238.74|
|Downside Capture vs Agg||22.07||100.0||28.36||-14.02|
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, four of the five sub-advisors produced negative returns. The Blackstone Credit Systematic Group’s Long-Short Credit strategy was essentially flat (down 0.04%). Water Island’s Arbitrage and Event-Driven strategy was down 2.88%, DoubleLine’s Opportunistic Income strategy fell 6.01%, the Loomis Sayles Absolute Return strategy was down 7.41%, and the FPA Contrarian Opportunity strategy declined 10.88%. (All returns are net of the management fee charged to the fund.)
Year to date through June 30, the returns are as follows: Blackstone Credit Systematic Group down 1.07%; Water Island down 2.73%; DoubleLine down 10.50%; Loomis Sayles down 12.07%; and FPA Contrarian Opportunity strategy down 13.73%.
Key performance drivers and positioning by strategy
Blackstone Credit Systematic Group (DCI):
The Long-Short Systematic Credit portfolio was essentially flat in Q2, even as the S&P 500 declined 16% and the U.S. 10-year Treasury dropped 5%. Risk-repricing dominated the market as the Fed moved forward rate hikes in response to the inflation news and recession fears emerged for next year. High yield index spreads were about 250 bps wider over the quarter, equity prices crumbled, and the VIX index jumped to end the quarter at 29. Treasury yields were also up on the quarter, driven by the torrid inflation data and the Fed’s move to jumbo-sized rate hikes. Interest rate volatility hit crisis levels as the ICE BofA MOVE index matched its COVID heights.
The portfolio continued to deliver mixed performance and was about flat in both the bond sleeve and Credit Default Swap (CDS) overlay for the quarter. The long-short CDS was flat as alpha traction continued to be challenging amidst the beta-dominant market moves, delivering on consumer short positions but declining on energy and transportation names. Alpha in the bond sleeve was more positive as long positions, especially in energy, held up well. But beta in the bond sleeve offset those gains and month-end pricing was a bit noisy. The rates component was about flat, as the rate-hedging performed as expected. The bond portfolio is well-hedged out the rate curve but retains some exposure to front end yields. This net duration has been close to a half year, which, while flat in Q2, accounts for most of the portfolio’s underperformance for the first half of the year.
The model’s views have not changed much over Q2 and DCI expects the portfolios may generate more consistent alpha as the market differentiates along fundamentals in the second half. The opportunity set has gotten large as spreads, volatilities, and dispersion of fundamentals and default probabilities are all elevated. The team continues to see balanced positioning across pandemic recovery names in the portfolio. Energy continues to be attractive, despite the market rally, because the sector recovery has gained traction and the longer-term prospects – particularly so given higher oil prices – look positive relative to spread levels. The portfolio risk spend is, as usual, primarily in idiosyncratic names and the portfolio continues to be unusually neutral in most sectors. It remains long energy and newly long again in consumer goods (favoring some selective retail and consumer brands), while running a bit underweight in financials. It also remains long technology (especially consumer-facing and networking) and short in telecoms.
For the quarter the DoubleLine Opportunistic Income portfolio was down about 6%, underperforming the Bloomberg US Aggregate Bond Index loss of 4.7%. This period in the markets was yet another challenging environment for financial assets of all kinds. US inflation readings remained persistently high, causing the Federal Reserve to continue pressing its hawkish policy agenda. The Fed raised its policy rate by 125 basis points over the quarter and also began tapering its asset purchasing program. As a result, US Treasury yields and fixed income credit spreads rose while equity indices experienced broad declines. The primary driver of the portfolio’s relative underperformance was asset allocation as the Fund held more credit-related assets than the Agg in a consistently risk-off market.
The top-performing sectors in the portfolio were shorter-duration, securitized credit sectors such as Asset Backed Securities (ABS) and Commercial Mortgage Backed Securities (CMBS). These sectors still experienced slightly negative total returns, but sharply outperformed comparable credit indices due to their high levels of interest income and muted spread volatility. The largest detractors from quarterly performance were Agency Mortgage Backed Securities (MBS) and US Treasury exposures. These assets experienced duration-related price declines as 10-year US Treasury yields rose 68 basis points over the quarter. Non-Agency Residential MBS and Collateralized Loan Obligations (CLO) also detracted from performance as their spreads widened due to concerns of a recession stemming from tightening financial conditions. The portfolio ended the quarter with a duration of 3.8 and a yield of 8.3%, while maintaining a cash balance of almost 11%.
The Contrarian Opportunity portfolio followed the downward path of equity markets during the quarter, dropping by almost 11%. The top contributors for the quarter were again relatively minor. Sound Holdings (0.7%), a shipping container partnership, was the only contributor above half a percentage point. Naspers and Prosus (0.3% combined) were the only other significant contributors. Not surprisingly, the largest detractors for the quarter were mainly high growth/tech names like Alphabet (-1.2%), Amazon (-0.7%), Broadcom, Meta Platforms, and Netflix (-0.6% each).
The portfolio largely retains its general “barbell” of high-quality, dominant franchise positions at reasonable valuations (much cheaper now, of course after significant valuation compression), largely in the tech and communications spaces, balanced with cheap but more cyclical value stocks like financials and industrials. There are also smatterings of interesting option-like positions, such as the basket of pre-merger Special Purpose Acquisition Companieis (SPACs) and a handful of cheap convertible bonds (new positions that are a good example of FPA’s flexible mandate to find value), in addition to the healthy cash balance, a “call option” on the ability to add risk exposure at significantly cheaper valuations if markets fall further. Despite some movement in underlying positions, overall exposures changed little over the quarter. Equities account for about 71% (over one-third in non-US positions), credit about 2%, private positions 2%, and cash 25%.
The Absolute Return strategy experienced another challenging quarter, falling 7.4%. High yield corporate bond spreads significantly widened during the second quarter, reflecting risk- off sentiment driven by challenging macroeconomic and technical dynamics. The portfolio’s high yield corporates detracted the most from performance. Consumer and communications issues were primarily responsible for the sector’s negative performance. Equities also faced a difficult environment due to hawkish Fed policy in response to persistent inflation. Within the portfolio’s equity allocation, communications and technology names had particularly negative impacts as those continued to suffer valuation compression in the face of higher discount rates. Despite supportive fundamentals, investment grade corporate bond spreads meaningfully widened over the second quarter amid uncertainty about inflation and the pace of central bank tightening. Consequently, Investment Grade corporates also weighed on the portfolio’s performance, with financial and communications names being particularly responsible.
The yields of the benchmark 10-year and 30-year US Treasuries experienced volatility during the quarter as a result of the persistent elevated inflation and Fed hawkishness. These key yields increased from 2.32% to 2.98% and 2.44% to 3.14% respectively. The portfolio’s global rates tools, primarily hedges using sovereign bonds and interest rate futures, contributed to performance. The portfolio ended the quarter with a duration of 1.8 and a yield of 6.4%.
The Water Island Arbitrage and Event-Driven portfolio was down approximately 2.9% in the quarter. Merger arbitrage generated a gross loss of about 2.6% while special situations lost about 0.3%.
The top contributor in the portfolio for Q2 was a position in the acquisition of Sanderson Farms by Cargill. In August 2021, Sanderson Farms – a US-based maker of fresh and frozen chicken products – agreed to be acquired by Cargill – a US-based conglomerate involved in agriculture, industrials, and financial services – for $4.5 billion in cash. Although this transaction is a vertical merger in which Cargill currently has no lines of business that directly compete with Sanderson (Sanderson produces chicken, Cargill makes chicken feed), the deal has undergone extensive regulatory reviews at the Federal Trade Commission (FTC) and US Department of Justice (DOJ), which have become increasingly stringent under the Biden administration. In the nearly 11 months since the announcement of the deal, Sanderson’s shares have traded higher on rising chicken prices and increased consumer demand. The spike has led to gains for the fund, though the shares now trade at a level where they exceed the deal value; as such, Water Island is closely monitoring the situation for further developments.
The second largest contributor for the period was a position in the merger of Change Healthcare and UnitedHealth Group. In January 2021, Change Healthcare, a US-based medical software and technology provider, agreed to be acquired by OptumInsight, a subsidiary of UnitedHealth Group (which also owns the country’s largest health insurer) providing medical information technology services, for $8.8 billion in cash. After a lengthy regulatory review, the DOJ sued to stop the transaction in February 2022, alleging the combination would harm competition in multiple markets. Despite the DOJ’s attempted block, Change Healthcare shares have rallied in 2022 based primarily on improvements to the company’s underlying fundamentals in the time since the deal announcement, leading to gains for the fund. During Q2, the companies agreed to revise the merger agreement to bump the deal value by $2 per share via a special dividend due at closing; implement a hefty break fee for Change Healthcare should the deal ultimately fail; and extend the merger date once again to allow time to fight the DOJ in court. Water Island is maintaining the position as UnitedHealth’s commitment to the deal is clear, although they are watching carefully and looking out for any changes in potential downside.
Conversely, the top detractor in the portfolio was a position in the terminated acquisition of Momentive Global by Zendesk. In October 2021, Zendesk – a US-based developer of software for customer support and customer communications – agreed to acquire Momentive Global – a US-based developer of software for conducting web-based surveys – for $4.1 billion in stock, after an activist investor in Momentive pushed for a sale process. In January, however, yet another activist investor – this time at Zendesk – began to push Zendesk’s board of directors and management to reject the acquisition, believing the company should instead be put up for sale itself. The very next month, Zendesk management rejected an offer from a private equity consortium that would have valued the company at $17 billion – yet Zendesk shareholders appear to have agreed with the activist, as they overwhelmingly rejected the Momentive deal mere days later. Subsequent share price volatility has led to mark-to-market losses for the fund; however, Water Island is maintaining the Momentive exposure as not only has its activist reemerged, but the proxy background of the Zendesk merger indicated there were at least two other interested parties who put forth bids for the company before Zendesk won the initial sale process. The Water Island team believes there is more left to the story.
The second largest detractor for the period was a position in the acquisition of Twitter by Elon Musk. In April 2022, Elon Musk – CEO of Tesla and SpaceX and one of the richest people in the world – launched an unsolicited bid to personally acquire the 91% of US social media company Twitter that he did not already own for $41.3 billion in cash. Musk put together a financing package combining commitments from a group of banks led by Morgan Stanley and private equity firms with his own personal assets, including loans backed by his holdings in Tesla stock. Musk’s commitment to the deal has seemingly wavered in line with the fortunes of Tesla shares, which traded down significantly after Twitter’s board agreed to the transaction. Musk’s capriciousness has led to significant volatility in this deal’s spread, and as of this writing he has officially attempted to back out of the deal. That said, merger contracts have become increasingly strong since the Global Financial Crisis, and it has become exceedingly difficult for even the most remorseful buyer to extricate itself from a definitive merger agreement.
Water Island Market Commentary
For the trailing three months leading to the halfway point of 2022, market challenges that commenced in the first quarter of the year continued. There has been no shortage of pressures conspiring to drive swings in broader credit and equity markets, including geopolitical tensions, runaway inflation, rapidly rising interest rates, and fears of an impending recession, to name just a few. Yet while our event-driven strategy has thus far largely adhered to its typically low beta nature, mitigating the worst of the market’s moves, it has not been immune to volatility spikes of its own. When capital market drawdowns extend beyond corrections into bear market territory, forced and panicked selling can cause correlations to converge across asset classes. Within the universe of announced mergers and acquisitions, for example, during Q2 spreads gapped wider as arbitrageurs exited positions en masse, even in deals where there has been no change to the underlying fundamentals of the transaction. We have seen similar behavior before – for example, in the midst of the Global Financial Crisis of 2008, and more recently at the onset of the COVID-19 pandemic in the first quarter of 2020. The magnitude of the spread widening has been dramatic, though we view these movements as mere mark-to-market losses. We continue to have conviction that the vast majority of pending deals will reach a successful conclusion (as over 90% of announced M&A has done, historically, according to Dealogic data), at which point their spreads will narrow to zero and losses will reverse.
In the months ahead, we do anticipate relatively higher levels of volatility to remain present, but we also view the current environment as favorable for our strategy, as the recent dislocation is presenting merger arbitrage investors with outsized return opportunities based on current spread levels. We believe deal spreads remain attractive both on an absolute basis and relative to other asset classes, and ongoing volatility may allow for opportunistic trading. We are also optimistic about the level of expected M&A activity in the latter half of the year, as deal pipelines remain robust. Fears of a recession and the accompanying market effects have not yet interrupted the appetite for corporate consolidation. While global M&A fell 17% in the first half of 2022 from the prior year, to $2.1 trillion in value according to Bloomberg data, 2021 was an unprecedented year for dealmaking. Despite the drop, the total value of deal flow in 2022 is still above historical averages for similar time periods. Furthermore, rising interest rates have historically served as a tailwind for merger arbitrage returns; thus, based on recent and anticipated Fed moves, we expect spreads in newly announced deals to remain attractive.
As we seek to deliver non-correlated return streams sourced from the outcomes of idiosyncratic corporate events, our goal, as always, is to do so with as little volatility as possible. We have minimized the portfolio’s exposure to soft catalyst opportunities – which tend to be more sensitive to broader market moves – and would only consider adding to our soft catalyst investments with appropriate risk mitigation strategies in place. That said, in the near term, the current environment for rates, volatility, and deal flow leads us to believe merger arbitrage and other hard catalyst merger-related investments remain the appropriate area toward which to direct our focus.
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, 2022
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top Five Sector Exposures|
|CDS Portfolio Statistics|
|Number of Issuers||73||73|
|Average Credit Duration||4.5||4.5|
|Spread||255 bps||244 bps|
|DoubleLine Opportunistic Income Strategy|
|Agency Inverse Interest-Only||6.9%|
|Non-Agency Residential MBS||33.2%|
|Collateralized Loan Obligations||10.8%|
|FPA Contrarian Opportunity Strategy|
|Asset Class Exposures|
Loomis Sayles Absolute Return Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||6.3%||0.0%||6.3%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||91.7%||-2.0%||89.7%|
|Merger Arbitrage – Credit||2.9%||0.0%||2.9%|
|Special Situations – Equity||0.5%||0.0%||0.5%|
|Special Situations – Credit||1.5%||0.0%||1.4%|
|Total Special Situations||1.9%||0.0%||1.9%|