Alternative Strategies Fund Third Quarter 2020 Commentary
All five sub-advisors generated positive performance during the quarter, and three of the five are positive for the year. MORE
Interviewee: Jeffrey Gundlach, DoubleLine
Interviewer: Jeremy DeGroot, Jason Steuerwalt
Date: November 17, 2020
Mike Pacitto: Good afternoon, everyone. I’m Mike Pacitto – Director of Institutional Relationships for the iMGP Funds at Litman Gregory. Thanks, everyone, for joining us.
Today we’re having a conversation, featuring this with Litman Gregory’s CIO – Jeremy DeGroot — and the founder, CEO and CIO of DoubleLine, Jeffrey Gundlach.
First, a brief update and outlook for the iMGP Alternative Strategies Fund, with coPM, Jason Steuerwalt.
A quick primer on the fund, as many on the call today own it or may be considering owning. Others may not be familiar with it.
This is our flagship liquid alternatives fund, with five unique underlying separate accounts within. Contrarian Opportunities from First Pacific Advisors – FPA. Absolute-Return from Loomis Sayles. Long-short credit from DCI. Arbitrage event-driven special-situations from Water Island. And the largest weighting within the fund – Opportunistic Income from DoubleLine – managed by Jeffrey Gundlach and Jeffrey Sherman.
Since the fund’s inception in 2011, the fund has handily beaten its Morningstar category, the HFRX and the Barclays Agg. With a negative correlation to core bonds – with nearly twice the yield – alongside a very low beta to equities, it’s been an excellent diversifier for fixed-income and a ballast in volatile equity markets.
Please feel free to punch in any questions that you may have for our presenters today in the q-and-a section. We’ll also try to get to the questions that were sent in to us in advance.
With that, Jason, I’m going to hand it off to you for a quick update of how the fund is positioned, and our outlook. Then we’ll get right to Jeffrey and Jeremy.
Jason Steuerwalt: Great. Thanks, Mike.
I’ll give a quick recap on the year. Then I’ll talk a little bit about the managers.
The fund was conservatively positioned coming into the year, based on high valuations in equity markets and tight credit spreads.
There was a high cash level in FPA’s sleeve. Water Island’s portfolio was overwhelmingly hard-catalyst/short-duration/merger-focused.
Loomis Sayles had almost no high-yield exposure, with almost two-thirds of their exposure in short-duration, high-quality investment-grade and structured credit.
DoubleLine had about a quarter in agency or government paper, and about 50% in legacy non-agency RMBS, which was yielding about 4% or so. Really, not far out on the risk-spectrum.
The year started off relatively smoothly. It was playing out about as we would have expected, even through the early stage of the crisis. The fund was down low-to-mid-single-digits, even as the S&P was down over 20% from its peak.
The fund wasn’t spared from the rolling market shocks, as the crisis intensified. There was a lot of forced selling from hedge funds in the merger space – especially in the credit space.
Hedge funds, mortgage REITs and even mutual funds had [BWIX] out, trying to reduce their exposure and raise cash. It’s a little bit like the GFC condensed into a two-week period. Tough times across credit markets.
Fortunately, our low-beta, less-correlated strategies held up relatively well. Our managers were generally able to pivot to being more aggressive to varying degrees.
That’s really a core element of the fund’s strategy – investing with managers that have been through battles like this before and know how to navigate these situations.
A couple of quick examples.
Loomis took off the hedges from their portfolio, and moved fairly aggressively into high-yield. Including fallen angels and even investment-grade that had gotten really beaten down as investors were forced to sell whatever they could to raise liquidity.
Water Island added to deals that they like best, that they felt had really strong merger agreements. In retrospect, really extraordinary spreads.
FPA added some high-quality travel-related names that not surprisingly were extremely beaten down, but that they felt had strong-enough balance sheets to weather a prolonged downturn in travel.
These moves paid off handsomely as the fund gained a lot of ground in Q2, and was in-the-black by the end of Q3. Through the end of last week, the fund was up about 3%, with 4 of the 5 managers in positive territory for the year. Two of them in the high single-digits; Water Island and Loomis Sayles.
We still really like the return potential, going forward. I’ll briefly run through the managers, to give a little bit of color on that.
Starting with DCI, this is our systematic long-short credit manager that combines market-neutral long-short CDS portfolio, with a cash-high-yield bond sleeve that’s hedged with CDX and treasury futures.
They still see an attractive spread opportunity. The average spread on their CDS book is above-average; meaning there’s good potential for convergence between the longs and the shorts toward their estimate of fair-value.
They tend to do best in a widespread environment, with reasonable volatility, and one that’s driven by fundamentals.
We think this should be a good environment for them as the market becomes more discerning between improving and declining credit quality. That’s not just driven by shifts from extreme fear where everything sells off, to extreme greed where people are chasing things on the way up. That’s what happened in March, then — after the Fed and treasury stepped in, on the way up.
Moving to DoubleLine.
About 50% of the portfolio is still in non-agency RMBS, with another third in other credit sectors. Mostly in structured credit. Primarily CMBS, CLOs and other ABS. It’s got a healthy yield of almost 6% and a duration of only 2.
These were the sectors that were most impacted by the forced selling among other market participants during the March period. It didn’t benefit directly from the Fed and treasury measures immediately following the crisis. They’ve kind of lagged the sharp rally in high-yield and investment-grade on the way back up. Which is part of the reason there’s still quite a significant yield in that portfolio.
It’s also what we think is a really favorable upside/downside return profile, as a lot of that book is still below-par. But the monthly remittance data comes in and shows the underlying performance of those loans behind the securities better than the worst-case expectations that the market had expected.
If we can move to FPA.
This portfolio was hit a little bit harder than we have normally expected, given how it was positioned coming into the year. That’s primarily because it had a decent – not huge – exposure to financials. And a couple of aerospace names. Although they were fairly conservative with a lot of recurring maintenance revenue, nobody really expected an almost complete shutdown of air travel for a long time.
Nonetheless, they were able to add to some names. They added a couple of credit names. It currently stands about 70% net-long equities. 5% credit. Almost a quarter in cash.
I think of this portfolio really as barbelled between some dominant high-quality business models. You can see a couple of the names, here. Alphabet, Microsoft – on one end. Then some extremely cheap but more cyclical sectors in financials. Some materials and industrials on the other end.
This portfolio is really poised to benefit strongly if the value-rotation continues. They also still have a lot of dry powder to be opportunistic in the event that there are other selloffs in either credit or equity markets.
Moving to Loomis Sayles.
As I mentioned, Loomis was conservative coming into the year. Almost no net-long high-yield exposure, at all.
But they were still hit a little bit in March, given the complete liquidation of pretty much everything in the credit market.
They pivoted pretty aggressively to high-yield. That’s been a strong driver of performance this year. They’ve still got quite a bit of high-yield, but they’ve reduced it quite a lot and gotten more conservative, given how much spreads have tightened over that time period.
You can see the yield-to-worst here is still over 5%, with a duration of about 4.
Lastly, Water Island is the best performer in the portfolio year-to-date. I mentioned before that they added to a number of their favorite deals – the ones they felt had the strongest merger agreements and were pretty much bullet-proof in March. Again, at really unbelievable levels – spreads you only see in the midst of a crisis.
The vast majority of their net exposure is still in the merger book, and we think there’s still a good opportunity set there. Spreads wider than pre-Covid levels. And a big rebound in deal volume, following – not surprisingly – a big falloff in Q2.
There’s also a decent allocation to special-situations in that sleeve of the portfolio. The majority of that is in SPACs. Water Island participates in the SPAC universe, across the deal life cycle there.
It’s been a really, really nice contributor to returns, year-to-date. Still a good opportunity set going forward amid record issuance this year, which continues to be strong.
Overall, I’d say we feel pretty good about the performance year-to-date. We think there’s a lot of upside left in the more directional parts of the portfolio – as well as a good environment for the relative-value and arbitrage strategies.
With that, I will turn it back over to Jeremy.
Jeremy DeGroot: Okay. Thank you, Jason and Mike. It’s my pleasure to welcome Jeffrey Gundlach to our call. For the remainder of our time – ’til about 1 o’clock – to have a q-and-a discussion with Jeffrey.
Welcome, Jeffrey. Good to see you again. How are you doing?
JG: I think you forgot to set your clock back. It’s already 1 o’clock.
JD: Sorry! Well, thanks for joining us! That was very instructive. Sorry about that! 2 o’clock! I’m in California. Are you down in LA? Or are you back East?
JG: I’m here in Pacific Palisades. I’m here at least a couple of times during the summer, but I’m staying out between now and early April.
JD: I think that would be wise.
Just to set the stage here, our intention is to go from big-picture and get an update on your macroeconomic view and see how that feeds into DoubleLine’s view of the investment opportunity set. The financial markets. Nearer-term and longer-term.
Then also dig in a bit into some of the specific risks and opportunities within the fixed-income world. The opportunity set that you have to work from for the Opportunistic Income Strategy that’s part of our Alternative Strategies Fund.
We’ve gotten a number of questions in-advance that were written in from listeners that I’m incorporating in here. We may get some live ones, as well.
Lots to cover, but why don’t we just jump in. Start with your big-picture macro view. There were a couple of people that referenced this, and I thought a nice way to lead into it would be just given the election results – presidential and congressional – that we’ve seen, and I guess it’s somewhat still playing out –
If that’s changed your near-term or longer-term view in setting the stage for your broader macro outlook.
JG: No, not really.
My highest-conviction idea relative to going into the election was that there would be no blue wave. If Biden won – and maybe he did; maybe he didn’t; we’ll find out. But it doesn’t really matter, to a certain extent.
No matter who won, I was pretty certain that the congress would remain split. I thought there was a horrible logic underneath the narrative – since Biden was way ahead in the mainstream media polls, which we all knew were overstating his support – [since May 16] –
A lot of people thought that true to historic patterns, you’d get down-ticket benefits.
If Biden were going to win by 12 percentage points, which I think was what CNN projected the day before the election – and it wasn’t even close – people thought that would lead to gains in the senate – and therefore, the blue wave thesis.
I had exactly the opposite opinion. My point of view was and is that people didn’t really vote for Joe Biden so much as the people that were in his camp were voting against Trump. They’d vote for anybody against Trump.
I made the joke they’d vote for an empty garbage can instead of Trump.
That coupled together with the fact that many Americans – I think it’s about two-thirds even of democrats – believe that Joe Biden, if he gets inaugurated, won’t make it four years.
In the back of peoples’ minds, I think, was Kamala Harris. She’s much more outspoken and direct in her opinions than Joe Biden, who is highly-evasive and malleable in the way he speaks about issues. Kamala has spoken pretty seriously about some of the leftist agenda.
Some people say organizations – they call themselves bipartisan, and they probably aren’t, really – but they say she’s got the most liberal voting record there is.
I figure that people would want an insurance policy. In the backs of their minds, they’d be thinking, “Well, I didn’t want Kamala Harris.” She dropped out with almost no support in the primaries.
“I don’t want Trump, so I’m going to hedge my bets and keep the republicans in charge of the senate.”
That took place.
I actually think that as the narrative was shifting going into the election and immediately after the election – the real narrative is what I’m talking about here.
It wasn’t, “Look. The market’s up,” so people liked Trump. Then all of a sudden, “Wait. The market’s up more. The might like Biden.” I think what they like is as little uncertainty on future policy as possible.
They certainly don’t want higher corporate taxes.
If you own the S&P 500, you certainly don’t want higher corporate taxes. That is one thing that Joe Biden seems committed to – at least partially.
I kind of think that the market likes this sort of divided situation.
There’s talk now that there’s going to be a descent – a bunch of Californians descending into Georgia to vote in a runoff election – to try to lift the senate. I think Andrew Yang said so in a Tweet. “The failed Democratic hopefuls.”
He says he’s moving to Georgia so he can try to help flip the senate.
I wonder if that’s possible. If you’re allowed to vote in a runoff election if you weren’t a citizen before the general election. I kind of doubt it. But that’s taken on a life of its own in our social-media world. It’s a bunch of people trying to recruit other Californians to ambush Georgia. I sort of doubt that’s going to happen.
JG: Anyway, we’ve got this divided situation. It leads to probably less of the dream case for stimulus. Looking for a blue wave –
You probably would have gotten another multi-trillion-dollar stimulus package. This one —
I’m getting very confused as to why we’re talking about stimulus packages. J Powell – I think it was this morning – said he’s thinking about –
Or it was some Fed official – I don’t think it was Powell – said they’re thinking about raising interest rates. I think Bank of America put out a research note that we should start bracing for higher short-term interest rates.
Then in the second part of the research piece, they talked about a stimulus package. That sounds a lot like putting on the gas and the brake at the same time.
I really believe J Powell – that they’re not going to raise interest rates for a very long time. He’s also gone so far as to say that in the next downturn, which I think we’re still sort of in the downturn – they’re not going to do negative interest rates. They’re going to do large-scale asset purchases.
That’s what’s got the bond market all screwed up. We’ve had about the lowest-volatility summer into the fall in my career. It probably is the lowest volatility. The range is so tight.
It was actually only a 20-bps range. It finally broke a little bit above it a couple of weeks ago. But we’re right back essentially into it with the 10-year at 87 bps.
The election, I think, ended like the last several elections with a divided government. Trump will probably, I think, go kind of crazy with more draconian measures on China. Particularly if he has to concede. He’ll want to leave his footprints on being tough on China. That’s one of his signature issues. I hear he’s thinking about that.
Those are things we have to brace for.
The election – it is odd. It’s not really over, yet. The runoff in Georgia I think is January 5th. There’s still quite a lot of time to go. That’s going to be the most-important issue. My bet is that the republicans will win at least one seat, for a 51-vote majority.
JD: Yes. Let’s talk a little bit about the economy.
You said maybe we’re still in a downturn. The last two quarters –
Second quarter was obviously severe. It was the worst quarter for GDP in US history.
JD: Coming off of that – a huge growth number doesn’t necessarily mean that much. But the economic indicators – the PMIs and the manufacturing services and so forth are indicating expansion mode.
I guess I just want to get your sense of, nearer-term, how you view the risk of a double-dip or another downturn. If this is reverting from this recovery. It would seem that Covid and policy are the two variables we’ve been talking about that are really driving the nearish-term macro outlook.
You touched on policy. Fiscal policy clearly is more up in the air now, without a Blue Wave. That’s one piece. Covid is another.
I guess the risk of just the economy in the short-term and what that would mean for financial markets.
JG: Let’s not kid ourselves. The economy recovered because of the most unusual policy response in American history. I guess that’s not even an exaggeration.
It was the first economic downturn that was a big economic downturn where we actually had an increase in personal disposal income. The increase was due to $3 trillion of transfer payments.
That’s what’s keeping the economy going. If you don’t have those transfer payments, you have a lot of permanent unemployment. You have a lot of small businesses that are already closed for good. There are many more that are going to close in the winter time that’s coming up, here.
The most-recent datapoint that I saw was 24% of all small businesses that were open at year-end 2019 are closed, right now. 24%. We’ve had an increase in consumer-spending – unbelievably – thanks to the transfer payments of the government. That’s never been. That’s just unheard of.
Obviously, a lot of the money made it into financial speculation. You can see that in the number of retail accounts that have been signed up for. The volume of trades. The incredible amount of call-buying that was going on in micro slices – thanks to the financial engineering of Wall Street. They were more than happy to help the retail investor participate with government money in the market.
But I think the economy has a lot of structural [unemployment] in it right now. I think that unemployment is going to climb up the income ladder.
It first hit, of course, very-low-income people. There are a lot of [baristas] laid off and waiters and bartenders and cruise-ship janitors. Hotel workers and all that stuff.
But one thing I think a lot of observers have failed to think about and appreciate – work-at-home has changed the way I think CEOs analyze their business. I’m just anecdotally seeing through my clients that our financial intermediaries have a lot of layoffs going on.
Our biggest client runs a huge variable of Moody programs – an insurance company. They informed us a few weeks ago that they were laying off hundreds of people that were in their wholesaler unit. That sort of thing.
They realized, first of all, that the environment isn’t really conducive to traveling salesmen right now. They also probably realized that maybe they didn’t really need all those people, anyway.
That’s happened in my own business. Thanks to virtual meetings, which we have every day – of course – like everybody else – and working a lot by e-mail – you start to get greater clarity on who’s really producing what.
It’s one thing when you’re in an office building and walk down the hall and you go to the manager of an investment team and say, “I’d like this report or this data set,” and a few hours later, they give it to you.
Then when you send it out to the entire team, the e-mail goes to 12 people or something – and you start to realize that it’s always the same three people that are getting back to you. They get back really quickly. The other nine people get back with –
Let’s say out of a dozen, six of the other nine people – I haven’t heard from them since March 13th when we went to work-from-home. You’ve got three others that are kind of sometimes showing up.
You start to wonder why you need that manager that you haven’t heard from since March 13th. You start to realize that they’re just watching other people work.
I think that that happens – the unemployment is going to climb the economic ladder.
I furloughed a couple of people just because I couldn’t for the life of me figure out what they were producing. I think that’s going to continue to happen.
What we’ve seen is highly unreliable economic data. I think that’s one of the most important points for people to consider. The economic data is completely skewed by the seismic shift in the economy.
Are average hourly earnings really going up? They sure looked like it. Particularly in the middle of the year. But most of that was because the low wage earners were the ones that got laid off. So the datasets are all non-comparable.
You mentioned the PMIs and by-extension, industrial production. Sure. They look great! When you dig a hole that deep, when you come out of it, it looks great!
We talk about portfolio performance. This year, if you look at the last six months, certain types of portfolios like my sleeve of your fund – it’s up like 10% in the last six months. It’s like, “Wow! This is doing great!” But it’s not all the way back.
It’s like that thing where you go down 10 and up 10 – you’re not back to 100.
I think this data is really murky. I do believe that this economic hit is very uneven across the economy. It’s been a real shock, I think, to the middle-management community. It’s above middle-class, but it isn’t truly wealthy and usually lives on debt. It usually doesn’t have any savings.
We always saw those statistics pre-Covid that so many Americans don’t even have $500 saved.
I’ve got to believe that the people with no savings were living loan-to-loan in their debt-based reality. They must have been scared to death in April.
If you have no savings and you’re used to a comfortable lifestyle and you’re starting to think about layoffs happening, I just think it puts the far of God in you.
I think the savings rate – I know the savings rate – is elevated at higher wage levels. Consumer-spending of higher-wage earners in the economy is still down a lot. I think it’s a dangerous word, but I’m going to use it – “never” – going to go back to where it was pre-Covid. Those people are starting to realize that they need a rainy-day fund more than they need another credit card.
I believe that consumer-spending is going to be hit. I think this general economic shock – at least initially – is deflationary. Certainly, we saw that immediately in the aftermath of lockdowns. It’s come back somewhat. I just think it’s disinflationary or deflationary on wages. I think there’re going to be changes.
We’ve already seen changes in mobility. People don’t want to live in densely-populated cities as much as they did. Particularly now that taxes are being raised and police are being defunded. People are looting stores in some of these cities. I just think there’s some movement there that’s really powerful.
I think it’s deflationary. I think it’s deflationary for San Francisco county home prices where the units that are up for sale – it’s like 4-times as much as it was in the last five years – where were all pretty similar.
You’re seeing a lot of people trying to move to Boise and Austin and all of that stuff happening. Those are cheaper areas to live. At least for now. And you don’t have to pay as high a wage.
If you have an employee like an IT person – you pay for a lot of office space in downtown Los Angeles like I was doing for these people. They’re basically just typing in the computer all day, anyway.
My IT department has told me and told me this months ago – they don’t think they’d want to go back to work at the office, ever. They don’t think there’s any need to!
In fact, they make the argument, and I completely concur with this argument – there’s actually a productivity benefit for an IT team to not commute to their office. They could be typing at their computer and coding, instead of looking at the bumper in front of them.
I really think this is kind of a negative long-term structure for the economy. But more, my fundamental point is that the narrative you hear all the time of, “Getting back to normal –
Like, “It’s going to go back to pre-Covid?” It’s not going to happen. There are going to be benefits that come out, in what we’ve learned from this. There are going to be losers. We’re going to have to watch it sort out.
But initially, until such time as they go hog-wild with money-distribution, I think as we’re doing it with lending facilities via the Fed, it’s disinflationary.
JD: Okay. That’s a good segue into the Fed, and also bond market interest rates. Obviously, so closely tied to inflation expectations.
Let’s first just quickly touch on the Fed, if we can.
They’ve introduced or discussed this average-inflation targeting framework. They’re saying, “We’re going to let things overshoot.” Obviously, the huge bond purchasing. The lending facilities. They threw in all the kitchen sinks they had, and they’re saying, “We’ve got more sinks back in the closet to put in.”
I think what Powell did today – he basically reiterated again that –
To quote, “The Fed is strongly committed to using all of our tools to support the economy for as long as it takes. Until the job is well and truly done.”
He’s saying it’s not time to put any of our tools away.
JG: Yes. He sounds like he’s preparing people for more and to ramp up their activity a little bit more. It’s been kind of “on,” for the last few months. They did trillions of dollars of purchases and violated their own charter and they’re presently in violation of the Federal Reserve Act of 1913. They’re not allowed to own corporate bonds – ever. Yet they own junk-bond ETFs.
JG: What’s concerning about the Fed is, since they are operating in plain sight, in violation of their own charter, it means you’ve kind of crossed the Rubicon. Now anything kind of goes. Once you violate the fundamental aspect of your charter, why not violate all of them?
The danger is that the Fed ends up kind of supporting an inflationist regime. They’re not there, yet. They’d actually have to go to a radical step of declaring their liabilities legal tender – which would be true money-printing.
What they’re doing right now, a lot of people call it money-printing – but it’s technically not. It’s a very wonky distinction that’s not really worth going into. But you’ll notice that we haven’t had inflation go up. We’ve been running global financial crisis policies now for 12 years. If you think about it.
Interest rates now – they’re basically –
It’s funny – I was looking at a webcast that I did in 2011 about two weeks ago. It was shocking how applicable the environment that was represented in that webcast slide deck is, to today.
Interest rates were the same. The Fed’s balance sheet was a big issue. When were we going to get off of zero? When would we get inflation higher?
The more I think about this –
(Un)Employment is kind of today about the same as it was in 2007.
One way to think about this is, we’ve never left the global financial crisis. We have exactly the same policies that we introduced to fight the global financial crisis. We’re talking about amping them up to new highs. And we have the same employment, basically. And still the same debt-based economic scheme.
If what we’re doing right now – even if you put it on steroids a little bit – if you believe that’s going to run into inflation, how come you don’t have inflation yet?
As you have a highly-indebted economy that this is, the more debt you pile on, the less-effective it is in generating economic growth per dollar of debt in generating both economic growth and inflation. This is kind of the paradigm we’re stuck in.
What the Fed wants is –
It’s interesting how they kind of massage you gradually into accepting a position, that to jump there in one step, you’d find very radical. Remember how it used to be a “ceiling,” of inflation of 2%? Then it was a “target,” of 2% and now it’s a “target” above 2% at least for a while – so that you can “make up,” for “past sins,” of being below 2%?
It’s pretty clear the Fed wants to monetize the debt. They want to do it very slowly. They want inflation to be higher than the interest rate. Right now, it sort of is. It’s kind of close. The interest rate is sort of higher.
The Fed understands that $157 trillion of unfunded liabilities of the United States cannot be paid back in today’s currency value. It can’t be done. You have to either restructure those liabilities or you have to debase.
One way to start debasing is to get the inflation-rate higher than the interest rate by a fair amount. That’s what the target is.
The Fed isn’t just willing to let inflation run hot; they want it to run hot.
JG: I think they’d be thrilled if the inflation rate went to 3.5% and if it stayed there for a couple of years. And if the 10-year treasury stayed at 1%.
You’d be on your way to taking small steps, anyway, to get at this liability problem.
One thing that’s also interesting is that average hourly earnings – which was a tricky number – because I said the dataset has shifted a lot – is higher than the 30-year mortgage rate. Right now, we’re actually helping to debase mortgage debt. On average.
There’s a lot of oversimplification in that analysis. First of all, average hourly earnings can go up next week. The mortgage rate is locked in for 30 years. But if it stayed at that dynamic, you’re actually right now helping to debase the mortgage debt.
You’re getting to the point where if you could get the inflation rate up to 3%, you’d start to debase corporate debt, as well. The average yield on corporate debt right now – at least at-market – is about 1.7% in the investment-grade market, and 2.25% in the triple-B market. There’s an awful lot of danger in the triple-B bond market with the size it’s grown to. What happens to triple-B bonds if they get downgraded into junk?
Spoiler-alert – they fall a lot in price.
It’s highly attractive to do a slow-motion. Maybe you start to put the accelerator on a little bit in debasement. That’s what the Fed wants to do.
That, I believe, kind of characterizes what’s happening with the Fed.
JD: Let’s talk about the investment implications. As you describe it, it sounds like, “Gee. I sure wouldn’t want to be a bond fund manager.”
JG: Well, now it’s okay.
JD: It’s the timing of it; right?
JG: The moment you felt that you didn’t want to be a bond fund manager was probably about February 20th. When yields fell on treasuries – at least initially on the short-end. There was no yield, there. Yet, you had all this risk of the over-valued stock market and over-valued corporate bond market – and everything else at very tight spreads, as well.
What’s happened, of course, is that the Fed instantaneously ratchetted the corporate bond market back to its old highs by violating its charter. High-yield bonds haven’t bounced all the way back, but they’re back a fair distance.
The Fed has supported those areas.
Now one way to think about that is, maybe it takes some of the risk away. I mean maybe. Maybe you don’t have to worry about it. If the economy hits another speedbump and corporate bonds drop another 20 points, maybe the Fed pings them back up 20 points, again.
I don’t think that’s a very good investment thesis, that they’re just going to hope that that happens.
Also, I think that the corporate bond market – at the yield it’s offering relative to its duration – is kind of nutty. Let’s just say it’s a duration of 9 and its yield in the investment-grade category –
The duration is 9 and the yield is 1.7%. That doesn’t sound like a good way to make money, when you have the risk of an economic downturn that could lead to downgrades in corporate bonds. You’d lose probably 10 years of income. If they’re 10-year maturity bonds, you’d lose all of your income in the downgrade of the ultimate default.
Opportunities do exist in the things that the Fed didn’t protect. They’re kind of wonky and esoteric. And they have obvious underlying concerns about them. That’s in commercial-mortgage-backed securities and it’s in asset-backed securities. Those types. Maybe in tranched-out corporate credit and the CLO market. Those are areas where you have an identifiable reason to get nervous.
It’s like hotel bonds – cruise ship bonds. Well, maybe. Maybe it’ll be okay.
But when you get into these capital structures that are tranched, which are CLOs and CMBS and parts of ABS – it’s actually a really good opportunity. It was really great six weeks ago. But with the vaccine news, they’ve started to –
It’s going to be a pretty strong month for CMBS and CLOs and stuff like that. The vaccine news popped the middle of the capital-structure, a lot. But that’s been the place to be.
If you look at the CMBS market, we looked at where the cliff was in various segments of the market. We decided that almost nowhere in the triple-B CMBS market will you take a loss. Even if you stress to double the global financial crisis defaults and knocked 20 points off of the recovery rate. You’re still money-good.
Some of these securities were trading down at $0.50 and $0.60 on the dollar. They’ve rallied, of course, but now they’re up maybe at $0.82 or $0.85. And there’s still room for these – we believe – money-good securities to go up another 15 points.
There are areas of the market –
We bought 25% of our portfolio that we’re managing for you all in those exact types of things. Middle of the capital structure.
They lagged a lot with the corporate bond market in April and May, when the Fed was targeting their programs. Triple-A CMBS snapped back completely because the Fed actually made them eligible for some of their lending facilities.
Then in the most recent months, opportunity-seekers started to realize as they were getting more and more data on the Covid fallout –
Quite frankly, the remittance data – the non-payments in CMBS – even in CMBS, but particularly in RMBS – it’s been shockingly subdued. The amount of non-payment is really low. It’s been falling gradually from its spike in April and May. It’s been falling, ever since.
I think the fallout appears to be less than we would have feared. Certainly double-the-default-rate of the global financial crisis – probably overly-conservative – but better safe than sorry. Those parts [in that area].
The other thing that we’ve started to think about is a weaker dollar getting more in-gear. I’ve been negative on the dollar since January of 2017. I actually turned positive in the short-term on the dollar for a trade back in August. It hasn’t really worked or not worked. It’s basically gone sideways since then.
But there is a strong correlation between the size of the twin-deficits and the direction of the dollar. Historically, and for good reasons.
The trade-deficit doesn’t matter, anymore. it’s actually shrinking a little bit because of world activity has slowed down somewhat.
The budget deficit just blows it away. I mean it’s 16% of GDP and it’s just unheard of. We’ve never seen anything like this. It strongly correlates to a weaker dollar with a 2-year lag.
I think the weaker dollar is probably going to get in-gear fairly soon. For that reason, one who’s a dollar-based investor can start thinking about currency trading. Currency bonds. In this case, I wouldn’t be buying Japan or Europe with their negative yields. I made a promise to myself I’d never buy a negative-yield bond, and I’ve kept that promise, so far.
If the market can ever have any positive-yielding bonds, I’m going to stay there.
But emerging markets should do pretty well. A great Covid play – if you believe in Covid-based improvement – emerging market debt is a great place to be. Emerging market equities are great, because just like CMBS and airlines and cruise ships back in May, emerging markets were an area where people really worried about Covid because the healthcare systems aren’t strong, and the like. Yet a weaker dollar would really make them do well.
Emerging market equities have been a mixed bag, this year. The Latin American ones were negative. They’ve rallied pretty sharply in the last several weeks. But Asian emerging markets are up like 20% year-to-date. It’s kind of shocking to see that divergence.
I think the weaker dollar will create investment opportunities. We haven’t had a really weak dollar since really the middle of the 00s. It’s going to be an important investment thesis.
We added some emerging market debt. We have about 5% in our portfolio. That was sort of an opportunistic thing, because the market was down a lot. But I also think fundamentally, we could very well be increasing that as we move forward into 2021.
JD: The dollar was a question on the list. I think you covered it well.
I have a couple of other points. There does seem to be a consensus view – at least medium-term – for dollar-depreciation. Some other points, in addition to the deficits, the real yields that have come down in the US. The real-yield curve, relative to other currencies. That’s compressed; right? We don’t have that advantage.
Then related to the global recovery, the USD is a safe haven, typically. If global growth rebounds, that tends to be consistent with a weaker dollar, which is beneficial for foreign markets and equities.
JG: Yes. I think the sentiment for the weaker dollar got to such a high level, that’s part of the motivation for why I took off my bearish view.
It really was almost 100% dollar-bears. Particularly against the euro. The euro has rallied. The dollar hasn’t rallied so much against emerging market currencies, but it has rallied a fair amount against the euro – which is an important one.
One thing I think about, though, is to be a safe haven, kind of means in the near-term that a strong dollar would probably be associated with a weaker stock market.
JG: That’s certainly what happened in March and April. I would expect that would happen again.
JD: Let me touch on emerging markets. This was a question I had on my list. I have a couple of others ask it as well – specifically, about China.
You’ve expressed a positive long-term view on India and Indian equities. The opportunity there.
But I don’t recall you talking as much about China. I just wanted to get your view into investment opportunities there, and how you view the risks.
JG: I’ve never gone long or short Chinese equities. I have just simply felt that the non-stop growth and debt level and the shadow banking system – all of that stuff –
But given the relative-performance and the situation that’s developed with global tension, a little bit, I’m actually sort of turning positive on China as an investment possibility.
They have a tremendous credit impulse that’s going on right now. It probably will filter through into stronger economic growth.
And, by the way, that credit impulse is a very strong indicator of rising industrial metals prices and industrial commodities prices. That’s already begun, finally. It was going down, down, down forever.
But that leads with about 12 months. The credit impulse has turned very positive.
I like Asian emerging markets for lower-risk investors. I like India for long-term investors. At this point, if you’re a high-risk profile person, I’d contemplate South American and Latin American equities. I hadn’t been at all fond of them prior to some of these economic developments looking a little bit rosier.
JD: One more on the equity market. Just curious of your take on it.
There’s of course been now about 13 years of growth outperforming value. Just to broadly define it.
JD: That’s been the endless bet. Okay. The rotation is happening. Now we’ve seen value actually has had a couple of months’ run in the US.
JG: But pretty strongly, lately.
JD: The Pfizer news – that day was one for the record books. I saw some research firm saying it was a 12-standard deviation event – which is as you know, one-trillionth to the x-power.
JG: I think it’s 10 to the 48th power.
JD: Okay – you’ve got it.
Either reality is wrong or the models are wrong. I’m going to bet on the models being right. But, I don’t know. You might have a different answer.
Just within the US equity market – to me, it ties into the view on global growth and whether people see that as sustainable versus these defensive long-duration growth stocks at very high multiples actually earning something in this challenging environment – in fact, have gotten competitive advantages from stay-at-home.
JG: I kind of think all these trends go together.
I think we’ve had really persistent trends of value underperforming growth and the US outperforming every other market in the world by a mile.
Of the super-6 being all the growth in the S&P 500. I mean if you look at the S&P 400 – 94 smaller-cap names – until very recently, they had two-year returns of zero. That meant nothing was going up.
I kind of see this Covid situation and the government response and all the fallout from it –
I kind of think that you can see the wind turning. You can sort of see, I believe, that these seemingly-forever trends are one-by-one starting to fall by the wayside.
It kind of goes to that bigger picture. I think the US will underperform the rest of the world stock market as the dollar is weak. I think value will outperform growth. I think commodities will outperform stocks, ultimately. I believe all of these things are changing.
I believe that interest rates would start to rise very rapidly. We’ll have to see what the Fed is going to tolerate in terms of rising interest rates. If they’re really committed to pegging the yield curve. They’ve used the words, “Yield curve control.” They did it in the 1940s and 1950s for the same reasons that they might do it now.
I think a lot of these things are changing. I’ve been talking about this for a while. It works in glacial time. People want to put a trade on and have instant gratification. But we’re talking about very long trends.
Actually, if we take the zoom lens out on an ever-wider zoom, that is that in 2017, there was the lowest-volatility year for the US stock market of all time. A narrative developed during that year that the market has changed structurally in a fashion. That means volatility – and here’s that word again – will “never,” come back.
Now I was on CNBC in July of 2017, and the VIX crawler was going by. It said, “9.85,” was the VIX level. That year it was below 10, dozens of times. Usually below-10 lasts for a minute. It was below for weeks at a time, multiple occurrences.
I was convinced that that was not going to endure.
Scott Wapner asked me, “What’s the highest-conviction idea you have?” I said, “I think volatility is going to go up pretty sharply, pretty quickly. In fact, I think the VIX would be above , relatively soon.”
When you go on CNBC, you might notice I don’t go on much TV anymore. I really prefer this to going on TV.
What happens is, if you say anything definitive, they have the next eight guests go on and talk about what an idiot you are and how you’re so wrong. “Doesn’t Gundlach understand the VIX will never go above 15 again? There’s a structural change.”
Well, I have to laugh, because it literally went above 15 the very next day. Of course, 15 looks really low by today’s standards.
I think we’ve had a regime change on volatility. I think we’re having regime changes all over the place. They fall one after the other.
Vol was one of the first ones to go. Vol really became systematic in the equity market in the fourth quarter of 2018. I mean we’ve had massive volatility for the last two years. We had a bear market in 2018 fourth-quarter. Then we had it rally all the way back. In some cases, to a new high.
Then we had an even-bigger bear market. Now we’ve had the greatest 30% increase in PEs in history. The six-month increase in PE was the greatest in history, I think, for the S&P 500 for six months from March into September.
I think volatility is just going to keep escalating. I think that’s a really good thing for active investors.
The regime we’ve been in for the last four months is great for my portfolio. I’ve got beaten-down stuff that’s lagging and is now recovering. It all feels good. But once all that stuff recovers, if you don’t have a volatile environment, you don’t have any opportunity.
Treasury rates are at 87-bps on the 10-year. Let’s just call it 1%. There’s no volatility. What are you going to do? Your dream is to make 1% in treasuries and 2% in corporate bonds.
I’m looking forward to that volatility.
I’m hoping and I guess I’ll choose to believe and not really predict that this time it won’t happen in four days and then recover in four minutes. Like what happened this time.
I hope it’s more like the global financial crisis, where you were actually able to transact with a reasonable bid-ask spread in the global financial crisis.
During March of this year, I don’t think many investors understand what the conditions were in the markets – particularly the credit market and the bond market. Even the treasury market. There were windows of time where you could not get a bid on off-the-run 10-year treasuries. You could not get a bid.
There were emerging market bonds that simply – the bid was zero. Nobody would even respond with a bid.
In the global financial crisis, the worst days, the bid was 40 and the ask was 45. That’s a pretty big bid-ask. But in March of this year, we saw one state reopened after being unable to be traded. We saw bid-50 and offer-70.
You can’t even transact. The value looks great at 50, but it’s not real. At 70, you’re sort of like, “Well, the bid’s 50. I’m not sure I really want to lift that 70 offer.”
Then of course the market didn’t stay in that dislocated condition for very long.
I’m hoping it gets a little bit more slow-motion, which will probably happen. The Covid thing was such an out-of-left-field. Even if there is – and it looks like the Covid stuff is getting a lot worse, and it looks like the only response that Joe Biden’s regime – if he gets inaugurated – would have, would be very harsh lockdowns. I just don’t see how he could do less.
His entire complaint is predicated on the idea that the government didn’t “do” enough. You’ve got to “do” more, if your whole point is that government didn’t “do” enough. If you get faced with a similar situation, you’re going to have to “do” more.
I think there’s a lot of economic danger underneath the economy with the spike in cases that’s going up. I know in many areas, they’re running out of hospital space. There are some real problems.
The good news is that the death percentage isn’t as high. Then you’ve got this hope for a vaccine, which I think is really overblown. I wish it were true, but –
I’d take this news more credibly if they came up with a vaccine and they said it worked like 53% of the time. There’s something about that 94.5% that just looks fishy to me. You go from 0 to 94.5%? I have a feeling it’s a very small sample. I have a feeling that it’s relative to one strain. These things mutate like crazy. That’s the problem with vaccines on Coronaviruses. They mutate like crazy.
We can’t get a durable vaccine on the regular influenza. We have failure rates of over 50% in some years. Then there’s the question of, “Will people take these vaccines?” Apparently, the ones they’ve tested with the higher rates, it’s super-unpleasant to take the vaccine. Apparently, you have to take it twice and it’s really painful. It gives you some fairly painful side effects. This is what I’m hearing from people that know more about this than I do.
I saw a survey from Gallup. Not that I believe polls, anymore. But this was a poll that said, “If you were given a vaccine from the FDA and they said they were positive it was safe, and it’s completely free and totally available, easily – would you take it?”
The answer that said, “Yes,” was 50%. That’s before they said – “And it makes you feel really sick for three days and it hurts like hell. Then you have to do it again two weeks later.” I think it’s going to be low.
I think this is a lot of –
I mean I’m all for optimism that some such thing could exist. But – I don’t know – 0 to 94.5 on a small sample, in a rapidly-mutating disease – I’m going to be from Missouri on this one.
Let me just jump in with a quick question back to the fixed-income. Someone asked about muni bond markets. It’s a pretty broad question, but –
JG: If you had a blue wave, munies certainly would have done better. Just again, for the tax reasons. Munies, I think, will probably be very disperse in their outcomes.
If you look at what happened in the aftermath of Covid, you saw a really big selloff in the muni market. Just like everything else. Then you saw the double-A-rated munies and single-A-rated munies rally back fairly quickly. Kind of like corporate bonds did. They kind of were on the back of corporate bonds.
I think people believed that under those conditions, the government probably would have bailed out some of these muni bond markets. Maybe not given money directly for the states as a first attempt, but at least done a buying program or something like that as they’ve done with other things.
I think you’ve got to be careful about what munies you own. There are some places – for now, I guess it’s okay to own California. But I think it’s going to get a lot worse. I think the revenues in California are sure to collapse, thanks to the already highly-observable exodus from California.
Just Elon Musk and Joe Rogan –
JD: Are you next, Jeffrey?
JG: I’m researching it.
It really depends on how suicidal the legislature really decides to be. They have proposals in place that I think are fully suicidal. If they pass them, I think I’m going to have to go into a more-aggressive mode of thinking about leaving.
They’re talking about a 16.8% tax bracket – which, of course, is non-deductible on the federal return. I doubt Joe Biden will return that. He might return it. He may return it partially. He’s not going to return it for me; I’ll tell you that.
16.8% and now they’re talking about a 40-bps wealth tax. That’s another proposal.
Now, 40-bps doesn’t sound that painful. But we all know how these things go. You start with the frog at 80 degrees and then it’s 85 degrees. Next thing you know, the frog’s dead.
I was doing research about Arizona. It was funny; I didn’t even know they had a tax-increase proposal, and it passed. The highest tax-bracket in Arizona just went from 4.9% to 8%. I’ve got news for you – that ain’t gonna be the last tier. They’re going to keep going, because they have to.
There are lots of changes that are going on there.
Munies – the tax-benefit is probably not going to go away. I think if you’re in states that are not in complete disarray in terms of their liabilities, I don’t see any problems with munies.
Let’s put it this way. I haven’t bought a muni in 8 years or 9 years, but I’ve reinvested. I have added money to my muni portfolio by reinvestment, and it’s all California. I’m still copacetic enough to not have made any shift, myself.
JD: Fair enough.
A couple of minutes left. I did want to shift gears and ask you a couple of broader questions. One, I guess, is just an update. If you’d be willing to give us an update on your professional plans or retirement timeline.
I’ve asked you about this in the past.
JG: I don’t think about retiring at all. If I’m thinking of moving out of California for tax reasons, it sort of suggests that I’d have a future timeline of income. If I were retiring, I’d just say, “Well, I’ll –
I mean there are other problems with California than just the taxes. The infrastructure used to be the best in the country. It’s now one of the worst. Used to be the best school system in the country. It’s now one of the worst.
The homeless problem is really depressing. I mean there are shanty-towns all over the place in areas that used to be pristine. Now there are shanty-towns all over the place. The 10 freeway, which connects the west side to downturn Los Angeles – you drive down there and if you do it in the afternoon when the sun hits the road in a certain way, you get a really good look at how much broken glass and garbage –
You’d think you’re in Bangladesh with the way the infrastructure is.
All of those are bad enough. They have started to defund the police. They’ve cut the police budget for Los Angeles County. These are not encouraging signs.
The taxes would kick me over the edge, for sure. I have no retirement plan.
I’ve talked about this for years. I’ve seen from a 40,000-foot overview that we’re going to have pretty massive societal change. Our institutions are going to change. There’s going to be rejection of the old institutions. I think right now, we can say that I’ve been on the right path in my thinking. There have been a lot of changes in the way people view our institutions.
If you think it’s weird now, wait four years. Like I said in 2016 – ” Trump’s going to win. If you think this one’s weird, wait ’til 2020.” I think I was right. I actually predicted there would be violence in the streets.
Then wait ’til 2024.
My point in saying all of this is I can see this is happening. I want to work through it. I want to see the end of it. I want to be able to see the sun shine when the clouds part on the other side of this hill. It’s going to be really good.
But that might take until 2027.
I’ll probably be around at least ’til then.
My last question is even broader. It’s about achieving long-term investment success. I think it incorporates –
My question is, what two or three attributes do you believe are most important for achieving long-term investment success?
I think it’s become even more challenging in the current environment. The range of outcomes – the uncertainty – the tales that are coming true, as you said. I mean maybe violence in the streets in the US.
JG: It’s already here.
JD: Yes. Already, it is here.
We’ve seen that. It’s not the first time, but just stepping back – if you had to give advice to someone early in their investment path, to be a long-term successful investor –
JG: The first thing is that you should extend your investment horizon. That’s the very first. Especially if it’s your own money. In that way, you don’t have to get second-guessed all the time.
If you have a long-term investment plan, you should extend that horizon and get committed to certain ideas. I’ll use my placeholder again – India. If you believe in my India thesis, which I’m strongly committed to – it’s basically going to do what China did. They’ll have a 30-x type of stock market return over a multi-multi-year horizon. Not 5 years. We’re talking 20 years; 25 years.
I think you should start getting committed to that. Then when you have selloffs, don’t be afraid. When you have selloffs that are significant, add to it.
Maybe a dollar-cost-averaging concept. Or maybe –
I don’t believe in dollar-cost-averaging. I think it’s too mechanistic. But a theme like that, where you’re adding when it’s down. Not worrying about it. That’s the hard part.
You could easily lose 30% of your money if you bought India, today. Easily. I’m talking about the big-picture.
For other peoples’ money, which I’ve figured out how to run that in a way that pleases a lot of clients – you can’t extend your horizon that far. When India goes down 30%, they’re all going to pull their money out.
You have to shorten that down to more of an intermediate-term rather than long-term horizon. For me, that’s about 18 months to two years. That’s about how it is. That’s another reason why I’d greatly prefer if we didn’t have these car-crash markets and that instead if it were more of a slower-motion train wreck.
The other thing – this is hard to teach people. You have to try to develop an emotional memory. What I mean by that is, when you experience really bad markets or something really bad happens in your portfolio, you’ve got to internalize how it feels. Like what the fear feels like. When it becomes palpable. Then to remember that.
I tweated out in late March – by good luck, I had entered the selloff in the equity market at about 300% short in my own personal high-risk thing. On the day Bill Ackman got yelled at for going on TV and saying that we were in a depression and the world was coming to an end – it turned out he was buying stocks; kind of a weird situation.
That minute that he was doing that, and the reaction on TV – I said, “This is it. I can feel the way this is behaving.” This is like March of ’09. This is like October of 1994, for the treasury-bond market.
I can see by the way people are behaving. You’d have to figure that out on the other side.
What totally saved my bacon during the global financial crisis was – A – I went into it with no credit, virtually. I was in a good spot. Then August of ’07 comes and the cracks started to form. The collateral in the mortgage market started getting marked down.
Bonds that were always at 100 – triple-A-rated bonds that traded at 100 all the time. They had a floating-rate component – they started to get margin-called at mortgage REITs.
One of the best mortgage-REITs in terms of their underwriting quality was Thornburg. It didn’t matter that they were the best underwriter. They were just getting margin-called. The liquidity was being drained out of the system.
One Friday afternoon, a bid-list came out and there were these bonds in there. These were a little bit different. They had some interest rate risk. But they were 6-coupon, fixed-rate, 30-year prime mortgage. And they never traded below par. And they were talking –
There were hundreds of millions of them on this bid list. They were talking of them at $0.97. I just threw a throw-away bid of $0.93. They were like, “$0.93? They’re never going to trade at $0.93.” Five minutes later, I owned 350 million of these bonds at $0.93.
He’s now the head of my agency MBS group, but then he was a younger guy, of course – he’s Russian. He’s got a great thick accent. He was like, “This is too cheap! I’ve never seen so cheap! This is the cheapest bond I will ever see!”
I had this crack-of-doom moment. Like lightening went down my spine and I was like, “You know what? We’re not buying any more of this stuff.” If this thing rallies back up, we’re going to sell it. Mark my words, these things are going to trade to yields of at least 15% on a payback basis.
I know how this stuff goes. When we have this one-sided margin-call type of event, it ain’t over at $0.93. Well, I made it right on the ticket. This was the cheapest bond I’d ever seen. We tacked it up on the wall.
Of course, the bond went to $0.45 on the dollar. It’s that feeling of, “Wait a minute. I’m filtering this information through a lens of experience with an emotional memory.”
It’s hard to develop. But you have to understand that you’re emotional, too. You have fear and greed. It’s very hard for people.
How many people were panicking in the retail equity market in the middle of March? A lot of people pulled out. Now they’re buying back at a P/E of 30. A CAPE ratio that’s the same as 1929. Market-cap to GDP the highest in the history of the United States. Corporate debt, the highest in the history of the United States. It’s like, “Really? You sold in March and you’re buying back now?” At least you’ll learn from that emotional experience.
JD: Well, experience is of huge value.
JG: The problem with the investment business is, when you finally get enough experience to be really good at it, people start asking you about your retirement plans.
JD: Well, I had to ask!
I’m happy to hear the answer is, “No plans.” But it’s always good to check in.
I think we’re a little bit over. I really appreciate, again, your time. And obviously, your investment expertise on behalf of our shareholders.
JG: You bet. I’m pretty optimistic we’re going to continue to see some good gains in the months ahead. I’m happy about that.
We’ll probably turn into a modest-single-digit return of the year. I think.
JD: That would be excellent. Thank you, Jeffrey and listeners. I’ll turn it back to Mike Pacitto to wrap up. Thanks, again.
JG: All right. Bye.
MP: Okay. Well, thanks, everyone. Nothing really to add from my end except we appreciate you joining the webinar today, and we hope you’ll join us for the next one. If you have any other questions about the fund whatsoever, feel free to reach out to us. All of our numbers and emails are here on the screen.
Thanks, and have a great holiday season.
All five sub-advisors generated positive performance during the quarter, and three of the five are positive for the year. MORE
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