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Commentary iMGP High Income Alternatives Fund Third Quarter 2022 Commentary

The iMGP High Income Alternatives Fund declined 1.34% in the third quarter, finishing well ahead of the Bloomberg U.S. Aggregate Bond Index (Agg), which fell 4.75% but slightly behind high-yield bonds (BofA Merrill Lynch US High-Yield Index), which lost 0.68%. The fund performed directly in line with its Morningstar Nontraditional Bond category peer group. Year to date, the fund was down 9.08%, outperforming both the Agg and high-yield bonds, which lost 14.61% and 14.62%, respectively, while trailing its category peer group (down 7.93%).

Past performance does not guarantee future results.  Index performance is not illustrative of fund performance.  An investment cannot be made directly in an index. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. To obtain the performance of the funds as of the most recently completed calendar month, please visit Investment performance reflects fee waivers in effect. In the absence of such waivers, total return would be reduced.

Quarterly Review

This year has been one of the most difficult investment environments in recent memory. The equity market (defined by the S&P 500 index) was down nearly 24% through September, while the Bloomberg U.S. Aggregate Index was down 14.6%, suffering its worst nine-month decline in its history.

Market volatility remained high across the bond and equity markets. Persistently high inflation resulted in many central banks around the world raising interest rates and reducing liquidity. To combat inflation here in the U.S., the Federal Reserve (the Fed) made its third 75 basis points rate hike in late September, lifting the Fed Funds rate to a range of 3.00% to 3.25%. This was the biggest three-month increase (225 basis points) in the Fed Funds Rate since the early 1980s. More hikes are expected through year-end as the Fed has voiced its intention to continue combating inflation.

Following the October 13th Consumer Price Index (CPI) release of 8.2%, Fed Funds futures (provided by CME Group) indicate a 95% probability that the Federal Reserve (“Fed”) will announce a fourth consecutive 75 basis point(“bps”) hike at the Fed’s early November meeting. The latest “Dot Plot,” which the Fed uses to illustrate its expectations for future Fed Funds rates, recently showed the key rate reaching a level between 4.25% and 5.00% in 2023, while one dovish prediction shows rates topping out at 3.75%-4%. For 2024, the dot plot shows a wide dispersion of forecasts ranging from 2.75% to 4.75%.

Looking at the real economy, the Fed has cut its economic growth forecast for 2022 through 2024 as it seeks to bring aggregate demand and supply back into better balance — reducing the demand side of equation via tight monetary policy. Inflation-adjusted gross domestic product (GDP) in 2022 is now anticipated to be 0.2% compared with the 1.8% the Fed predicted in June. The Fed expects next year’s real GDP growth to be 1.0% vs. the 1.7% projected in June. For 2024, economic growth is now forecasted at 1.7% vs. the 2.0% estimate issued in June. In addition to rate hikes, the Fed has implemented Quantitative Tightening allowing $30 billion of Treasuries and $17.5 billion of mortgage-backed bonds to mature monthly. Beginning in September those levels increased to $60 billion and $30 billion per month, respectively.

Looking ahead, inflation and Fed policy will continue to be major drivers of the bond market. This year, there have been meaningful changes to the U.S. Treasury Yield curve. The curve has moved higher, flattened, and certain parts of the curve have inverted. The curve has shifted higher as the Fed has raised rates, lifting the front end of the curve, and the longer maturities have adjusted accordingly. As for the shape of the curve, the yield curve typically has an upward slope meaning that investors require more yield for holding longer-term securities. An inversion occurs when shorter-term securities offer higher yields than longer-term securities. While seemingly odd, as there is no additional compensation for holding longer-term securities, inversions happen periodically. Usually this is due to short-term rates rising due to Fed rate hikes, while yields for longer-term maturities are impacted due to concerns that the Fed tightening policy may hurt the economy. Typically, curve inversions are brief, and are perceived as a reliable indication of recession.

Within the credit market, there seem to be two competing forces as uncertainty remains prevalent. On one hand, investors are attracted by today’s higher yields, but simultaneously, they are concerned about inflation, a still-hawkish Fed, and a recession, all of which could push yields higher and spreads wider. Indeed, yields in the credit market have increased meaningfully throughout the year and are at levels not seen in years. This environment has created attractive opportunities for our credit managers, who have selectively added risk exposure, while still exercising caution. Both credit managers’ portfolios were yielding close to 9.0% at the end of the third quarter with a duration of 2.3. We would remind investors that our credit managers focus on identifying attractive and durable, higher-yielding securities, often in niche, off-benchmark segments of the credit universe such as asset-backed securities (ABS).

Neuberger Berman’s option strategy continues to play an important, complementary role in the fund. The high option premiums collected helped somewhat offset losses from the equity market declines of the quarter. The strategy’s annualized yield changes quickly due to the Neuberger’s laddered approach to portfolio construction and the options market repricing risk, but it was in the upper 20% range at the end of the quarter. Additionally, materially higher yields on short-term Treasuries, while a detractor during the quarter as yields rose and prices declined, will provide a longer-term benefit to the option sleeve’s collateral return; the collateral portfolio yielded 3.9% at quarter end. (The weighted average duration of the collateral is less than 1 year.)

The High Income Alternatives fund reached its four-year anniversary at the end of the quarter. This time-frame has allowed the fund to demonstrate its advantages, and we think it is poised to potentially produce attractive risk-adjusted returns and income, while diversifying core bond exposure. Over the trailing one-, two-, three, and since-inception periods, the fund remains ahead of both the high-yield and Aggregate bond benchmarks, as well as the Morningstar Nontraditional Bond category.

We appreciate your continued confidence in the fund.

Quarterly Portfolio Commentary      

Performance of Managers

During the quarter, all three managers posted losses. Brown Brothers Harriman declined 0.33% and Guggenheim was down 1.41%. Both outperformed the Aggregate bond index (down 4.8%) significantly, with BBH also beating the high yield index (-0.7%). Neuberger Berman fell 1.96% compared to a 5.76% loss for the CBOE S&P500 2% OTM PutWrite benchmark. (All sub-advisor returns are net of the management fees that each sub-advisor charges the fund.)

Manager Commentaries

Brown Brothers Harriman

The BBH sleeve reported performance of -0.33% in the third quarter and -6.22% for the first nine months of 2022. BBH continues to outperform other intermediate fixed-income market alternatives this year.  For example, the Bloomberg U.S. Aggregate Bond Index fell 4.75% this quarter and is down 14.61% year-to-date by comparison. 

For the quarter, adverse interest rate movements were the main driver of negative performance across fixed income. Actions by the Federal Reserve and the more aggressive policy statements made late in the quarter accelerated the time frame for additional interest rate increases to combat persistent inflation. As a result, 2-Year and 10-Year Treasury note yields increased by 132 bps and 81 bps, respectively. These movements brought total interest rate increases for the first nine months of the year to 355 bps for the 2-Year Treasury note and 232 bps for the 10-year Treasury note.  We continue to manage the sleeve at a 2-year duration to protect capital against potential further adverse rate moves.  

In contrast to the sharp movements in interest rates, the reaction of credit spreads to concerns about Federal Reserve actions and a potential recession were fairly muted this quarter after spreads widening significantly in 2Q.  Investment grade BBB-rated credit spreads were essentially unchanged from the end of the second quarter, and high yield BB-rated credit spreads actually tightened by 50 bps from the wide levels experienced at the end of the second quarter. 

Whether we are headed for a mild economic slowdown or full recession, we remain confident in our current investments and, as always, stress-test all of our purchases.  It is our expectation that default rates will continue to rise off the abnormally low levels of less than 2% per year experienced over the past few years towards a more normal annual level of 4-5%. The increase in default rates is already being priced into credit spreads. Our focus has always been on owning durable credits at attractive valuations that can perform across a wide range of potential economic outcomes.   

Guggenheim Investments

The outlook for the U.S. economy remains negative. Headline real GDP growth numbers have been impacted by volatile foreign trade and inventories but underlying domestic demand has been consistently slowing this year and is now contracting. High inflation has driven consumer sentiment near all-time lows, as real incomes and accumulated savings are eroded. We are well past the peak in real goods spending, and the rebound in spending on services will fade as pent-up demand is exhausted. Business investment is also weakening due to the sharp tightening in financial conditions and a more challenging outlook for economic growth. The housing sector is also subtracting from GDP as the spike in mortgage rates has cratered demand.

We now expect both 2022 and 2023 will see negative real Gross Domestic Product (GNP) growth (Q4/Q4), with a high probability of a recession starting by mid-2023. The only bright spot for the economy has been the labor market, with labor demand far outpacing supply despite weakening economic growth. Given hiring difficulties over the past two years, companies may be reluctant to shed workers even as the economic outlook worsens, but a continuation of weak economic growth will eventually lead to higher unemployment.

Inflation has broadened out from goods impacted by supply chain snags to housing and the services sector. Moderation in goods prices should bring inflation lower over the next several months, but housing and services inflation will remain elevated amid the tight labor market, keeping inflation above the Fed’s comfort levels until mid-2023, at the earliest.

The Fed is aggressively tightening policy and won’t be deterred by recession. This aggressive posture is meant to reassure markets and the public that it will do whatever it takes to ensure price stability. We see a high likelihood that the Fed will raise rates by 50-75 basis points at the next few meetings, as they aim to take policy well into restrictive territory. We expect the fed funds rate will reach a terminal level slightly above 5% by the second quarter of 2023. The Fed is looking for “clear and convincing” evidence that inflation is coming down before scaling back on restrictive policy. This high bar means that not only will they need to see several months of cooler inflation readings, they will also need to a see a weaker labor market to ensure wage growth moderates and takes pressure off underlying inflation. Fed communication has made it clear they are aware of elevated recession risk, but they see the risks of letting inflation expectations become unanchored as far more dangerous. Fed policy is unlikely to pivot to rate cuts as quickly as in the past, even amid rising unemployment. We don’t expect the first cuts until the end of 2023.

Despite recession risk, fiscal stimulus is unlikely given inflation concerns. The likelihood of divided government after the midterm elections will result in policy gridlock.

As for the portfolio, we are turning more defensive but remaining opportunistic as the credit cycle reaches an inflection point. Corporate fundamentals remain solid with manageable debt service, but defaults and bankruptcies are gradually increasing. We expect more defaults in the next 6-12 months as the lagged effects of tightening financial conditions are felt. Weakening corporate earnings growth expectations have triggered a net downgrade cycle for corporate credit ratings. Corporate bond valuations reflect the challenging environment ahead with most sector spreads near or above their 60th percentile levels historically, but spreads may widen a bit further.

We continue to find attractive relative value in leveraged loans, high-yield corporates, and asset-backed securities. Fixed-income yields look compelling and spreads compensate for likely defaults in the next year.The Fed’s aggressive rate hike campaign should cause the yield curve to invert further. As the economic cycle rolls over next year, Treasury yields should see a significant decline.

Neuberger Berman

In the third quarter of 2022, the sleeve was down approximately 2%, slightly besting the PutWrite Benchmark, which consists of 40% Cboe S&P 500 PutWrite Index and 60% ICE BofA 0-3M US Treasury Bill Index, loss of 2.42%.

Equity Markets

The S&P 500 Index jumped 9.2% in July and fell 9.2% in September. Normally, August’s 4.1% decline would seem more significant were it not sandwiched between two months pushing double-digits. Non-US developed equity markets (MSCI EAFE Index) did enjoy the gains of July but found its way to an August loss of 4.7% and a September decline of 9.3%. Emerging markets (MSCI Emerging Markets Index) marched to their own beat, as they often do, with roughly flat returns for July (-0.2%) and August (+0.5%), saving an 11.7% fall for September. Overall, the three markets posted third quarter returns of -4.9% (S&P 500), -9.3% (MSCI EAFE), and -11.4% (MSCI EM), respectively. In September, the S&P 500 Index (“S&P 500”) capitulated -9.2%, the Cboe S&P 500 2% OTM PutWrite (“PUTY”) dropped -5.0%, and the Cboe Russell 2000 PutWrite (“PUTR”) fell -5.8%. Over the Quarter, the S&P 500, PUTY, and PUTR lost -4.9%, -5.8%, and -4.7%, respectively.

US Treasury Markets

As short-term rates continue to rise on the back of the Fed’s inflation flight, we continue to reset collateral portfolios at historically attractive short-term US Treasury rates: 2-Year US Treasury rates pushed above 4.0% during the quarter reaching levels not seen since the third quarter of 2007. Over the month, short-term US Treasury rates (3M US T-Bill) rose 35bps while the long-term rates (10Y US Treasury) were up 64bps. In conjunction, on the quarter, short-term US rates were up 160bps and 10Y US rates gained 82bps.

Option Implied Volatility Indexes

As expected, implied volatility levels responded in kind with the Cboe S&P 500 Volatility Index (“VIX”) rising above 31 for the first time since June. While VIX’s quarter-over-quarter increase was modest, the intra-quarter period included a 50% increase from August lows below 20. VIX futures markets ended the quarter relatively unchanged despite losses in equity markets and remain well above their long-term averages. Higher levels of implied volatility over the quarter adequately anticipated increased realized volatility which yielded a positive average S&P 500 implied volatility premium. For the quarter, the Cboe S&P 500 Volatility Index (“VIX”) rose 2.9 pts yielding an average 30-day implied volatility premium of 3.1. (Higher levels of implied volatility premium are better for the strategy.)

Strategy Allocations

The fund’s target allocations across the three managers are as follows: 40% each to Brown Brothers Harriman and Guggenheim Investments, and 20% to Neuberger Berman. We use the fund’s daily cash flows to bring each manager’s allocation toward their targeted allocation should differences in shorter-term relative performance cause divergences.

Sub-Advisor Portfolio Composition as of September 30, 2022

Brown Brothers Harriman Credit Value Strategy
Bank Loans31%
Corporate Bonds45%
Guggenheim Multi-Credit Strategy
Bank Loans25%
Corporate Bonds39%
CMBS (Non-Agency)2%
Preferred Stock4%
RMBS (Non-Agency)4%
Neuberger Berman Option Income Strategy
Equity Index Put Writing  100%

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Dividends, if any, of net investment income are declared and paid monthly. The Fund intends to distribute capital gains, if any, to shareholders on a quarterly basis. There is no assurance that the funds will be able to maintain a certain level of distributions. Dividend yield is the weighted average dividend yield of the securities in the portfolio (including cash). The number is not intended to demonstrate income earned or distributions made by the Fund.

Though not an international fund, the fund may invest in foreign securities. Investing in foreign securities exposes investors to economic, political and market risks, and fluctuations in foreign currencies. Investments in debt securities typically decrease when interest rates rise. This risk is usually greater for longer-term debt securities. Investments in mortgage-backed securities include additional risks that investor should be aware of including credit risk, prepayment risk, possible illiquidity, and default, as well as increased susceptibility to adverse economic developments. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. Derivatives may involve certain costs and risks such as liquidity, interest rate, market, credit, management, and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. The fund may invest in master limited partnership units. Investing in MLP units may expose investors to additional liability and tax risks. Multi-investment management styles may lead to higher transaction expenses compared to single investment management styles. Outcomes depend on the skill of the sub-advisors and advisor and the allocation of assets amongst them. The fund may make short sales of securities, which involves the risk that losses may exceed the original amount invested. Merger arbitrage investments risk loss if a proposed reorganization in which the fund invests is renegotiated or terminated.

Diversification does not assure a profit nor protect against loss in a declining market.

Asset-backed security (ABS) is a financial security collateralized by a pool of assets such as loans, leases, credit card debt, royalties or receivables.

A basis point is a value equaling one on-hundredth of a percent (1/100 of 1%)

Below Investment Grade bond is a bond with a rating lower than BBB.

Collateral is something pledged as security on a loan to be forfeited in the event of default.

Collateralized put-write is an options trading strategy that involves short positions in put options and the use of the underlying stock as collateral.

Contango is a situation where the futures price of a commodity is higher than the spot price.

A coupon or coupon payment is the annual interest rate paid on a bond, expressed as a percentage of the face value and paid from issue date until maturity.

Distribution yield:  The trailing twelve month (TTM) income distribution yield is the sum of a fund’s total trailing interest and dividend payments divided by the last month’s ending share price (NAV).  12-Month Yield gives you a good idea of the yield (interest and dividend payments) the fund is currently paying.  The trailing twelve month (TTM) total distribution yield is the sum of a fund’s total trailing interest and dividend payments plus capital gains distributions divided by the last month’s ending share price (NAV).  12-Month Yield gives you a good idea of the yield (interest and dividend payments and capital gains) the fund is currently paying.

Duration is a commonly used measure of the potential volatility of the price of a debt security, or the aggregate market value of a portfolio of debt securities, prior to maturity. Securities with a longer duration generally have more volatile prices than securities of comparable quality with a shorter duration.

Floating interest rate, also known as a variable or adjustable rate, refers to any type of debt instrument, such as a loan, bond, mortgage, or credit, that does not have a fixed rate of interest over the life of the instrument.

Futures are derivative financial contracts that obligate parties to buy or sell an asset at a predetermined future date and price

Investment grade bond is a bond with a rating of AAA to BBB

Mortgage-backed security (MBS) is a type of asset-backed security that is secured by a mortgage or collection of mortgages.  Commercial Mortgage Backed Securities are backed by mortgages secured by commercial real estate.  Residential Mortgage Backed Securities are backed by mortgages secured by residential real estate.

Options are a financial derivative sold by an option writer to an option buyer. The contract offers the buyer the right, but not the obligation, to buy (call option) or sell (put option) the underlying asset at an agreed-upon price during a certain period of time or on a specific date.

Barclays Aggregate U.S. Bond Index is a market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most U.S. traded investment grade bonds are represented. The index includes US Treasury Securities (non-TIPS), Government agency bonds, Mortgage backed bonds, Corporate bonds, and a small amount of foreign bonds traded in U.S

The Bloomberg.  Credit Index is an unmanaged index that includes strategies with exposure to credit across a broad continuum of credit sub-strategies, including Corporate, Sovereign, Distressed, Convertible, Asset Backed, Capital Structure Arbitrage, Multi-Strategy and other Relative Value and Event Driven sub-strategies.

The CBOE Russell 2000 PutWrite Index (PUTR) is designed to track the performance of a hypothetical strategy that sells a monthly at-the-money (ATM) Russell 2000 Index put option.

The CBOE Russell 2000 Volatility Index (RVX) is a key measure of market expectations of near-term volatility conveyed by Russell 2000® Index (RUT) option prices. The RVX Index measures the market’s expectation of 30-day volatility implicit in the prices of near-term RUT options traded at CBOE.

The CBOE S&P 500 PutWrite Index (ticker symbol PUT) is a benchmark index that measures the performance of a hypothetical portfolio that sells S&P 500 Index (SPX) put options against collateralized cash reserves held in a money market account.

The CBOE S&P 500 2% OTM PutWrite Index (PUTY℠ Index) is designed to track the performance of a hypothetical passive investment strategy that collects option premiums from writing a 2% Out-of-the Money (OTM) SPX Put option on a monthly basis and holds a rolling money market account invested in one-month T-bills to cover the liability from the short SPX Put option position.

ICE BofAML 0-3 Year U.S. Treasury Index tracks the performance of U.S. dollar denominated sovereign debt publicly issued by the U.S. government in its domestic market with maturities less than three years.

ICE BofA Merrill Lynch 1-3 US Year Treasury Index is an unmanaged index that tracks the performance of the direct sovereign debt of the U.S. Government having a maturity of at least one year and less than three years.

The ICE BofAML U.S. High Yield TR USD Index is an unmanaged index that measures the performance of short-term U.S. dollar denominated below investment grade corporate debt publicly issued in the U.S. domestic market.

The MSCI EAFE Index measures the performance of all the publicly traded stocks in 22 developed non-U.S. markets

The MSCI Emerging Markets Index captures large and mid-cap representation across 24 Emerging Markets (EM) countries. With 845 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3,000 Index.

The S&P 500 Index consists of 500 stocks that represent a sample of the leading companies in leading industries. This index is widely regarded as the standard for measuring large-cap U.S. stock market performance.

VIX is a trademarked ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30 day period.

You cannot invest directly in an index.

Credit ratings apply the underlying holdings of the fund, and not to the fund itself. S&P and Moody s study the financial condition of an entity to ascertain its creditworthiness. The credit ratings reflect the rating agency’s opinion of the holdings financial condition and histories. The ratings shown are all considered investment grade and are listed by highest to lowest in percentage of what the fund holds.

Mutual fund investing involves risk. Principal loss is possible.

iM Global Partner Fund Management, LLC has ultimate responsibility for the performance of the IMGPFunds due to its responsibility to oversee the funds’ investment managers and recommend their hiring, termination, and replacement.

The IMGP are Distributed by ALPS Distributors, Inc. LGM001273 Exp. 01/31/2023