The iMGP Alternative Strategies Fund (Institutional Share Class) gained 0.39% in the third quarter of 2023. During the same period, the Morningstar Multistrategy Category was up 1.54%, the Bloomberg US Aggregate Bond Index (Agg) was down 3.23%, and the ICE BofA 3-Month Treasury Bill Index returned 1.31%. Year to date (YTD) through the end of the quarter, the fund was up 2.42%, compared to the category’s 4.66% return, a loss of 1.21% for the Agg, and a 3.60% 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 that their original cost. Current performance of the fund may be lower or higher than the performance quoted. The Advisor has contractually agreed to waive a portion of the management fee through April 30, 2024. Performance data current to the most recent month end may be obtained by visiting www.imgpfunds.com.
We think the Fund’s 2.4% YTD gain through the end of September is okay. Not great, but not terrible, especially in the context of the Agg being down over 1% this year through the end of the quarter, and down even more in the first few weeks of October, while the fund remained relatively flat, widening that YTD performance gap to the neighborhood of 5 percentage points. We like the outperformance, but we were and still are expecting better absolute returns.
There have been a series of words and phrases in the financial media the last few years that have stood out for their ubiquity, if not always for their accuracy. Some that spring immediately to mind: transitory; unprecedented; pivot; soft landing. And the latest: higher for longer. That one has really impacted markets this year, especially recently, again punishing interest-rate sensitive areas like long duration bonds after a brutal year in 2022. The IDC US Treasury 20+ Year Index was down 9.53% through September 30, and down several percentage points more through the first few weeks of October. Somehow the NASDAQ 100 is still levitating at a mid-30s percent gain for the year, due at least in part to the excitement around artificial intelligence, although it’s still in negative territory since the end of 2021. ‘Higher for longer’ has delayed what we thought would be a strong payoff for the fund given the very high yields on the fixed income and credit-oriented parts of the portfolio, as well as very good spreads in merger arbitrage portfolio.
We still think we’re going to see quite attractive returns, but it has been frustrating to wait. To the extent that there’s a slight silver lining, it’s that we were right in our assessment that the return profile of the areas we overweighted or kept unchanged were significantly skewed in our favor, meaning that we could gain a lot if we were right and probably still achieve small gains or only minimal losses if we were wrong, which we more or less have been so far. It’s another reminder that even when things look like “fat pitches,” there’s no guarantee they’ll work out the way you anticipate, especially in the short- to medium-term. (Hence our high bar for deviating materially from our strategic allocations.) The upside we envisioned in our scenario analysis has so far been elusive. However, we also had a hard time envisioning reasonably likely downside scenarios where we’d suffer materially negative relative returns over the next 3 to 6 quarters or so, which — fingers crossed — has proved true so far.
As we step back and survey things from a big-picture perspective, although we’re clearly expecting a lot from credit in the upcoming quarters (the blended YTM (yield-to-maturity) from DoubleLine and Loomis Sayles sleeves is 9.9%), there are a good variety of investment styles and return drivers in the portfolio. In addition to the sizeable yields and deal spreads in the merger book, more than ever, there are very significant diversification benefits from uncorrelated strategies (that are also attractive on their own). Finally, it’s worth noting that the fund has a healthy level of dry powder that should allow it to remain opportunistic. Despite being somewhat underwhelmed by performance so far this year, we’re pleased to again have done significantly better than the losses from core bonds. As fellow shareholders, we remain excited at the fund’s potential going forward.
iMGP Alternative Strategies Fund Risk/Return Statistics 9/30/2023
|MASFX||Bloomberg Barclays Agg||Morningstar Multistrategy Category||Russell 1000|
|Total Cumulative Return||50.12||15.65||41.18||372.49|
|Annualized Std. Deviation||4.72||4.15||4.21||14.70|
|Sharpe Ratio (Annualized)||0.52||0.07||0.46||0.89|
|Beta (to Russell 1000)||0.27||0.08||0.25||1.00|
|Correlation of MASFX to…||100.00||34.00||90.00||83.00|
|Worst 12-Month Return||-10.04||-15.68||-5.71||-19.13|
|% Positive 12-Month Periods||75.94||63.16||73.68||86.47|
|Upside Capture (vs. Russell 1000)||25.83||8.62||24.51||100.00|
|Downside Capture (vs. Russell 1000)||26.49||8.32||27.68||100.00|
|Upside Capture (vs. AGG)||74.86||100.00||62.83||233.20|
|Downside Capture (vs. AGG)||20.62||100.00||16.83||9.48|
|Past performance does not guarantee future results. Indexes are unmanaged and cannot be invested into directly.||||As of 09/30/2023 Since inception (9/30/11)|
Quarterly Portfolio Commentary
Performance of Managers
For the quarter, three of six sub-advisors produced positive returns, led by the Water Island’s Arbitrage and Event-Driven strategy, which gained 2.22%. The DBi Enhanced Trend strategy (+1.74%) and Blackstone Credit’s Long-Short Credit strategy (0.25%) also finished in the black. On the negative side, losses were mostly modest compared to both equities and core bonds, with the Loomis Sayles Absolute Return strategy (-0.16%), DoubleLine’s Opportunistic Income strategy (-1.05%), and the FPA Contrarian Opportunity strategy (-1.72%) all declining by relatively small amounts. (All returns are net of the management fee charged to the fund.)
Key performance drivers and positioning by strategy
Blackstone Credit Systematic Group:
The Long-Short Systematic Credit portfolio returned 0.3% in the third quarter. Alpha performance for the quarter took a step back after a strong first half. Long-short selection in the credit default swap (CDS) sleeve contributed most of the negative performance. Rates hedging and beta hedging were in line with expectations and net contributed positively along with the corporate bond sleeve. The hedging again kept the macro footprint of the portfolio well-behaved.
Security selection gains were positive in corporate bonds, led by long energy names. Transocean was the best performer. REITs were also a positive contributor, while consumer durables (housing and autos) were a drag. Security selection in CDS was negative, retracing somewhat after a strong run in the first half of the year. Negative performance was widespread, reflecting a market retrenchment, led by long positions in consumer durables – especially housing and travel related – and in airlines, transport and leisure. Short positions in consumer retail and steel were also detractors. Financials again stood out as a positive contributor.
Portfolio positioning continues to favor long consumer durables and experiences/leisure over retail and consumer goods, and to favor energy over transports. Energy positioning has grown recently. The portfolio is increasingly short hospitals and long financial institutions and insurance. Over the quarter, credit differentiation in the market – which had been an important theme – took a backseat. The portfolio continues to be underweight to high-default-probability names and tilted into stronger credit quality. Going forward, Blackstone expects the positive alpha environment from earlier in the year to continue and for “up in quality” to be rewarded in the market. With an economic retrenchment and profit slowdown still looming, a sorting of credit into winners and losers is looking likely and should provide ample opportunity for continued credit selection gains later this year and into next.
As discussed extensively in prior letters, this has been a humbling period for most market strategists. The taper trade was dead wrong. The “Year of the Bond” turned into the “Year of Cash.” The overnight banking crisis … was solved by morning. We’re still waiting for the “delayed impact” of higher rates. Nothing big broke. For hedge funds, an added complication has been how to make money off “correct” calls. Nail “sticky inflation” – as did the CTA world — and good luck holding your positions through the Silicon Valley Bank/Credit Suisse bond market unwinds. Stock pickers who rationally concluded that higher rates would translate into higher returns in value stocks flat out missed the AI wave. For relative value investors, the long-awaited valuation convergence between non-US and US stocks has yet to materialize.
For traditional investors, two big trades have worked this year: growth stocks and cash. Ironically, in January those were contradictory macro calls – i.e., higher rates should have been good for cash but bad for growth stocks. Then AI fever hit – and who cares about rates when you’re on the cusp of a new tech revolution? — and the Nasdaq popped 35% through September, pulling the S&P 500 with it. Outside the Magnificent Seven and a few others, the report card is dismal: most equity categories have underperformed cash, most bond categories are in the red, REITS are down, and the obvious inflation hedges — TIPS and gold – are not working for the second year in a row.
The great challenge is how to think about where we go from here. Our simple view is as follows: spending is addictive. Governments like to spend money because their voters (today) like it. Companies prefer to hire than fire. Splurging on another vacation is a lot more fun than adding to a rainy day fund. Throw in structural issues like deglobalization, and all this suggests that inflation will be a tough nut to crack. For two years, many allocators have hoped that the surge was ephemeral; it might be time to battle plan for a very different world order.
After the height of the AI frenzy in the second quarter, markets came back to fundamentals with a renewed focus on inflation and interest rates. The Federal Reserve hiked rates and continued to give higher terminal rate guidance which sent the 10-year Treasury yield over 70 bps higher during the quarter. The rise in yields put pressure on risk assets. Aggressive short positions in Treasuries profited from the move in interest rates, however, net long positions in equities partially offset gains. The model cut long biased equity risk in half during the quarter which helped to contain losses. Higher rates in the U.S. continued to be a tailwind for the U.S. dollar against global currencies. A spread trade using the US dollar of long euro and short yen partially detracted from performance. Short positions in gold benefited the portfolio while oscillating positions in crude oil somewhat detracted.
In the third quarter the portfolio outperformed the Bloomberg US Aggregate Bond Index return by over 200bps (-1.05% vs. -3.23%). This period was characterized by declining global growth, surging yields, and a materializing “higher for longer” interest rate narrative in the market. Regional banking woes were replaced by fears of a rapidly growing US budget deficit – and despite US inflation moderating over the quarter, it continued to run above target.
Interest rate sensitive sectors struggled as US Treasury rates ended the quarter considerably higher across the curve. The 5-, 10-, and 30-year US Treasury tenors rose by 45, 73, and 84bps, respectively, as term risk premiums expanded sharply in the final weeks of the quarter. Subsequently, Agency RMBS and US Treasuries were the worst performing sectors.
Credit sensitive sectors were mixed; corporate credit and ABS generated positive returns while non-Agency RMBS and CMBS detracted from performance. Floating-rate products broadly outperformed over the period due to their high levels of interest income and low interest rate duration. As a result, Bank Loans and CLOs were the top performers for the quarter. The portfolio ended the quarter with a duration of 5.1 and an 11.0% yield.
The Contrarian Opportunity portfolio fell by roughly 2% during the quarter. Top positive contributors included tech/communications companies Alphabet (0.4%), Charter Communications (0.3 %), and Comcast Corporation (0.2%). Additionally, the collective position in oil services company McDermott International, comprised of multiple post-reorganization securities, benefitted from the sharp increase in oil prices during the quarter, adding 0.3%. The largest detractors included TE Connectivity Ltd. (-0.3%), Analog Devices, Inc. (-0.3%), Compagnie Financiere Richemont SA (-0.2%), International Flavors & Fragrances Inc. (-0.2%) and Bollore SE (-0.2%).
Activity was again relatively light during the quarter, with no material increases or decreases in existing positions. There were a handful of small new positions added, including a Korean food products company and a senior bond (with very significant credit support via junior bonds) in a stressed CMBS structure with equity-like expected yields. The portfolio’s position in Activision Blizzard was exited during the quarter as it traded significantly higher on positive news that suggested its acquisition by Microsoft would finally be approved by all necessary regulatory bodies. (The deal has subsequently closed successfully.)
The portfolio largely retains its general “barbell” of high-quality positions at reasonable valuations, largely in the tech and communications spaces, balanced with cheap but more cyclical value stocks like financials, industrials, and conglomerates/holding companies. However, it is beginning to have a small but noticeable segment of newer positions (both debt and equity) in companies directly or indirectly impacted by the challenges in the real estate industry. Gross and net long exposure to equities is approximately 58%, lower by over five percentage points. The largest sector concentration is in communication services, with financials and industrials following. These three sectors comprise approximately 58% of the equity portfolio. Meanwhile, credit exposure continues to methodically increase, ending the quarter at almost 8%, the highest level in some time. FPA has historically added to credit exposure significantly during periods of market stress and is waiting for the opportunity to do that more aggressively when corporate spreads widen. As noted, the team have begun to slowly add to positions in areas impacted by rolling stresses in the economy, including financials and real estate, some of which is in credit. Cash is approximately 30%.
The Absolute Return strategy was down very slightly in the quarter. The portfolio’s allocation to global rates instruments (short positions in interest rate futures) contributed positively to quarterly performance. US high yield corporate bond spreads marginally widened over the quarter, but the category was broadly helped by higher carry and below-average interest rate sensitivity. The portfolio’s allocation to high yield bonds positively impacted performance, with communications names responsible for the largest impact.
During the third quarter, securitized markets broadly produced largely positive returns, with the exception of non-agency CMBS and Agency MBS. CLOs and Commercial ABS provided particularly strong returns over the period, with portions of the RMBS market also outperforming. Headwinds facing the commercial real estate sector persisted, negatively impacting non-agency CMBS performance over the period. The shorter duration in most securitized credit sectors led to outperformance versus corporates in total return terms. A challenging technical backdrop negatively impacted Agency MBS as elevated levels of rate volatility continued and rates sold off. The portfolio’s allocations to CLO and ABS issues were primarily responsible for the sector’s overall positive impact on quarterly performance, while CMBS and non-Agency RMBS issues had a modest negative impact.
Emerging market assets experienced a challenging environment during the third quarter, with the effect of rising interest rates exacerbated by a downturn in foreign currencies versus the US dollar. Emerging markets assets detracted from the strategy’s performance, with Chinese exposures being primarily responsible. The portfolio ended the quarter with a duration of 2.6 and a yield of 7.9%.
The top contributor in the portfolio for the third quarter was a position in the acquisition of VMware by Broadcom. In May 2022, VMware – a US-based software company specializing in cloud computing and virtualization technology – agreed to be acquired by Broadcom – a US-based semiconductor manufacturer focused on telecommunications and storage products – for $61.4 billion in cash and stock. The companies previously extended the termination date of this deal, as in-depth investigations from multiple global antitrust regulators have caused delays in receiving required regulatory clearances in several jurisdictions. During the course of the quarter, the deal received key regulatory clearances in the UK and EU, and the waiting period for antitrust review in the US expired without objection from local competition regulators. Furthermore, in September, it was reported that antitrust regulators in China – the jurisdiction of the deal’s sole outstanding approval – had paused their review and advanced remedy talks with the parties. The deal spread narrowed on the favorable news, leading to gains for the fund. The companies are guiding toward an October 31 completion date. Other top contributors for the period included positions in the acquisition of Activision by Microsoft and the acquisition of Horizon Therapeutics by Amgen. The spread in the Activision deal narrowed significantly over the course of the quarter due to positive regulatory developments. Microsoft’s success in receiving antitrust clearance in the US and EU led competition regulators in the UK to reopen their review of the deal, and as of quarter-end Microsoft has proposed new remedies that UK regulators appear poised to accept. Similarly, the Horizon deal spread narrowed after the FTC abandoned its lawsuit to block the deal, instead negotiating a consent agreement with Amgen that would clear a path for the merger to proceed.
Conversely, the top detractor for the quarter was a position in the acquisition of Silicon Motion Technology by MaxLinear. Silicon Motion Technology is a Taiwan-based fabless semiconductor company that designs and develops high-performance, low-power semiconductor solutions for the multimedia consumer electronics market. In May 2022, the company agreed to be acquired by MaxLinear – a US-based provider of radio-frequency analog and mixed-signal semiconductor solutions for broadband communications applications – for $4.0 billion in cash and stock. The deal received all required shareholder and regulatory approvals, including in China, where the transaction had undergone a protracted review and whose approval was the final hurdle to close the deal. However, mere hours after China approval had been received, in a surprising move, MaxLinear terminated the merger agreement, claiming a material adverse effect had occurred in Silicon Motion’s business. It appears unlikely that this was simply a tactic for MaxLinear to seek a price cut, and Silicon Motion seems disinclined to take MaxLinear to court in an attempt to force the company to close the deal – but in response, Silicon Motion did claim MaxLinear breached its own obligations under the merger agreement and is seeking termination fees and will pursue additional monetary damages in arbitration. Other top detractors included positions in TEGNA and Rogers Corp, both of which are positions in the targets of previously terminated transactions which experienced volatility during the quarter. Water Island views these positions as dislocated securities and are following their standard deal break protocols, seeking to unwind the exposures in an orderly fashion.
Water Island Market Commentary
For several months leading up to the start of the third quarter of 2023, merger arbitrageurs faced an increasingly challenging regulatory environment in the US, where both the Federal Trade Commission (FTC) and the Department of Justice (DOJ) grabbed headlines in their efforts to impede mergers and acquisitions (M&A). These enforcement actions were often, in our opinion, based on novel legal theories that were not supported by legal precedent. Scarcely more than a week into the quarter, however, cracks that had already formed in the aggressive posture of the DOJ and FTC began to fracture even further. After multiple defeats in court (to the extent that the FTC and DOJ, under the current administration, had lost more cases that actually went to trial than they had won), in early July, the US District Court for the Northern District of California denied the FTC’s attempt to block Microsoft’s acquisition of video game developer Activision – the largest software deal ever – stating the theories of harm espoused by the FTC in its case were not supported by the facts. Furthermore, the FTC’s attempt to appeal was swiftly rejected.
We believe this has emboldened the parties to M&A, making them more willing to fight potential regulatory objections. We saw this more recently with Amgen’s planned acquisition of Horizon Therapeutics, which was met with an FTC challenge based on what we viewed as a perplexing justification with no historical precedent. The companies vowed to fight, and ultimately the FTC abandoned its case and reached a settlement that allowed the deal to proceed. We also believe the FTC and DOJ have begun to dial back their rhetoric and have permitted certain mergers which just 12 months ago they may have sought to block. For example, Broadcom’s acquisition of VMware – about which regulators voiced skepticism and was met with a second antitrust review request in Q4 last year – and the acquisition of identity management platform ForgeRock by Thoma Bravo – a private equity “roll-up” transaction that would see the target merged into several other smaller businesses (a practice which antitrust reform advocates have suggested warrants heightened scrutiny). Despite these issues, the US antitrust review waiting periods for both deals expired without any objections from the FTC or DOJ, tacitly granting the transactions approval.
Throughout the volatility in the merger arbitrage space, we were steadfast in our belief that the rule of law would prevail and that M&A transactions – which we believe are overwhelmingly constructed by dealmakers who understand the confines of the law – would continue to close. As such, we remained fully invested and aimed to capitalize on any volatility we encountered by trading around deal spreads opportunistically and seeking favorable entry points in our highest conviction positions. In Q3 our conviction was rewarded as the regulatory dominoes began to fall. Confidence amongst the broader community of arbitrageurs surged, driving spreads narrower across a broad swath of deals during a period when broader credit and equity markets struggled.
As antitrust fears have begun to diminish, it should come as no surprise that we have simultaneously begun to see signs that companies are becoming more confident in pursuing M&A transactions. In 2023, overall deal flow has remained subdued relative to record-breaking levels experienced from 2020-2021; however, in Q3 M&A activity ticked up from the lows earlier in the year, including the announcement of Cisco’s $28 billion acquisition of Splunk – one of the largest software deals of all time. Should the Federal Reserve’s pause on additional interest rate hikes persist, increased certainty around funding costs is likely to further reassure acquirers. The software industry appears particularly ripe for consolidation, where large-cap buyers – many of whom are flush with cash thanks to improved margins and higher interest rates – could be on the offensive in strategic M&A as organic growth rates slow. Software has also become fertile ground for private equity firms to put capital to work. With these green shoots in the M&A universe, we anticipate a healthy rebound in deal flow will continue in 2024.
Deal flow, interest rates, and volatility are the three major factors underpinning merger arbitrage spreads. Rising and elevated interest rates have historically served as a tailwind for the strategy’s returns, while volatility can provide opportunities to trade around deal spreads and find attractive entry points. Given the healthy level of current interest rates (and our expectation that we may be in a higher-for-longer rate environment), as well as our expectations for deal flow and ongoing broader market volatility in the face of a multitude of macroeconomic headwinds, not only are we optimistic about our strategy’s prospects in the months ahead, but we believe there may be no better time to seek out the benefits of its non-correlated return profile.
The current allocations, reflecting the DoubleLine tactical overweight are 27% to DoubleLine, 17% each to DBi and Water Island, 15% to Loomis Sayles, 13% to Blackstone Credit Systematic Group, and 11% to FPA. (The fund’s strategic targets are: 20% each to DBi and DoubleLine, 18% to Water Island, 15% each to Blackstone Credit Systematic Group and Loomis Sayles, and 12% 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, 2023
Blackstone Credit Systematic Group (DCI) Long-Short Credit Strategy
|Bond Portfolio Top Five Sector Exposures|
|CDS Portfolio Statistics|
|Number of Issuers||68||68|
|Average Credit Duration||4.5||4.5|
|Spread||172 bps||160 bps|
|DBi Enhanced Trend Strategy|
|Asset Class Exposures (Notional)|
|DoubleLine Opportunistic Income Strategy|
|Agency Inverse Interest-Only||7.7%|
|Non-Agency Residential MBS||38.2%|
|Collateralized Loan Obligations||14.4%|
|FPA Contrarian Opportunity Strategy|
|Asset Class Exposures|
Loomis Sayles Absolute Return Strategy
|Long Total||Short Total||Net Exposure|
|Cash & Equivalents||10.2%||0.0%||10.2%|
Water Island Arbitrage and Event-Driven Strategy
|Merger Arbitrage – Equity||87.9%||-12.5%||75.1%|
|Merger Arbitrage – Credit||2.9%||0.0%||2.9%|
|Special Situations – Equity||1.2%||0.0%||1.2%|
|Special Situations – Credit||3.1%||0.0%||3.1%|
|Total Special Situations||4.3%||0.0%||4.3%|