Interviewee: Jason Steuerwalt
Interviewer: Mike Pacitto
Date: October 24, 2023
Hi everyone, I’m Mike Pacitto with iM Global Partner. Thanks for joining us for this video update on the iM Global Partner Alternative Strategies Fund. I’m joined today by Jason Steuerwalt, Head of Alternatives here at iM Global Partner and co-Portfolio Manager for the fund.
After a brief update on some selected metrics, we’ll dive into each of the underlying strategies for more in-depth commentary on performance, positioning and outlook. Overall this video update should clock in at around 15 minutes. We appreciate your time and hope you find it well-spent.
As clients already know, earlier this year we upped our allocation to the DoubleLine Opportunistic Income strategy – we still believe this tactical overweight is very attractive, Jason will get into details on that later. Otherwise, the underlying distinctive orientation – a diverse grouping of separate account strategies unique to this fund – remains intact.
In terms of performance of the fund, you’ll see here that the fund has meaningfully outperformed t-bills and the Agg Bond index as well as the Morningstar peer group since inception. In fact, the fund has consistently remained in the top decile of its peer group in terms of Sharpe Ratio since it launched in 2011.
And while the fund was down in 2022, it was down much less than equities and core bonds. The fund is positive for 2023 through September Q3 with a 2.42% return, which is better than the Agg Bond index by over 360 basis points.
Along those lines, while many clients use the fund as a core alternative fund, many other clients use it more specifically as a diversifier for their bond portfolio. In this respect, the Alternative Strategies fund has really shined – it beat the Agg Bond index in 2022 by over 400 basis points, and historically since inception annualized has beaten the Agg Bond index by over 220 basis points, while maintaining a similar standard deviation volatility level and yield, with very low correlation, thus providing real diversification benefits to bond allocations.
In fact, the fund’s downside average return has been less than a quarter of the Agg during down periods, and the upside/downside characteristics have been very favorable. This is why we see many consultants and institutional investors continue to like this strategy for immunizing so to speak their bond portfolios.
Okay Jason, let’s get more in-depth here on the underlying managers and strategies.
At a high level the Fund’s 2.4% gain through YTD through the end of September is OK. Not great, but not terrible, especially in the context of the Agg being down over 1% 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 500bps.
There have been a series of words and phrases that have stood out (not always for their accuracy) the last few years that spring to mind: Transitory. Unprecedented. Pivot. Soft landing. And the most recent: Higher for longer. That one has really impacted markets recently, crushing interest rate sensitive areas like long duration bonds. TLT, the iShares 20+ Year Treasury Bond ETF is now down in the low teens YTD. (Somehow the NASDAQ 100 is still levitating at around +35% for the year, I guess due to the excitement around AI, 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 credit-oriented parts of the portfolio, as well as very solid spreads in merger arb book.
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 have small gains if we were wrong, which we more or less have been so far. Timing is never easy. But we had a hard time getting to a realistic scenario where we’d actually lose money over the next 3 to 6 quarters or so, which, fingers crossed, has proved right so far.
Pg 6 – Blackstone/DCI
This is a strategy and group within Blackstone Credit that people may not know well, so I usually give a quick refresher. This team, formerly known as DCI before Blackstone acquired them, uses their proprietary multi-factor model to calculate default probabilities across the corporate credit universe and translate those to fair value credit spreads, which they then use to go long or short the most misvalued credits. The strategy they manage for our fund consists of a long-short market neutral CDS portfolio and a cash bond sleeve that’s predominantly HY, where credit beta and interest rate duration are hedged to low levels. The intention is for individual security selection to drive performance over time rather than rates or credit spreads. This sleeve of the fund is one of the least correlated to traditional assets and other managers, and has historically performed very well during market stress periods.
As we note here, in Q3 the strategy gave back some of the gains it made in the first half, but is still nicely positive for the year. The CDS sleeve, which had been performing very well, contributed most of the negative performance, which was broad based rather than highly concentrated in any sector.
The cash bonds performed better. Rates and credit beta hedging performed in line with expectations and were overall a net positive in combination with the corporate bond sleeve. The hedging overall has done a good job of minimizing the impact of macro factors on the strategy’s performance.
Credit differentiation had been an important theme for much of this year, but took a backseat somewhat in Q3. Going forward, Blackstone expects, and we agree, that being “up in quality” should again be rewarded. Economic growth has remained stronger for longer than many expected, including us, but there are signs of potential profit slowdowns, and higher refinancing costs mean the potential for significant credit performance difference between corporate winners and losers is looking more likely. If that resumes and potentially accelerates it should provide a strong opportunity set for long/short credit selection.
Pg 7 – DoubleLine
As Mike mentioned, we tactically overweighted DoubleLine’s sleeve at the beginning of this year, as we believed and we’ve highlighted the very attractive high level portfolio characteristics here, namely the yield of about 11% and low average dollar price, creating what we think is a compelling asymmetric return profile. It’s only up less than 2% YTD but we’re still expecting very strong performance over a multi-quarter timeframe.
Losses for the quarter not surprisingly came from longer-duration assets like Agency MBS and Treasuries. Credit was mixed, with floating rate assets like CLOs and bank loans doing quite well and other areas producing smallish losses.
I talked last time about the portfolio’s barbell construction of duration and credit, which should be a natural internal hedge of sorts. And I’ll sound like a broken record, but that construct is significantly more attractive than it has been in years, even more so now than at our last update, given that yields for the safer, longer duration assets, namely Treasuries and Agency MBS, are even higher than a quarter ago. And they were already much, much higher than they were for most of the last decade, without the typical negative convexity of Agency MBS. In that government guaranteed part of the portfolio, you can likely get a hedge against economic weakness and potentially significant gains from a flight to safety, while enjoying a high level of carry and not much further downside even if rates increase at a moderate pace rather than a dramatic spike.
That’s a good balance for the credit exposures that make up the rest of the book. Non-guaranteed securitized assets (non-Agency RMBS and CMBS, CLOs, and ABS) collectively make up about two-thirds of the portfolio and yield 12%.
So again, we really like this portfolio’s setup, and hopefully patience will be well rewarded.
Pg 8 – DBi
As a reminder, this is a strategy we custom designed with DBi, consisting of a 75% allocation to trend following and 25% to Equity Hedge replication with some additional risk control tweaks. The timing of the addition last year was terrible, there’s no other way to put it, as we got one decent month and then a historically bad stretch of performance for trend-following, including dramatic losses in March related to the massive rally in bonds, stemming from the regional bank failures. The EH allocation was beneficial in tempering the negative stretch somewhat.
It was gratifying to see DBi’s portfolio rebound strongly since then, up a lot in Q2 and a little in Q3, but up over 2% in September, which was obviously a tough month for traditional assets. Q3 performance was driven by significant short positions in Rates and Bonds across the curve, and to a lesser extent by a short gold position and long oil in the last few weeks of the quarter.
YTD, Currencies are still the largest positive factor, as the short Yen position has been the gift that keeps giving. And the Bonds category is now positive for the year. Remaining short Bonds through the March banking crisis has helped performance significantly since then. Many people thought that might be the beginning of rate cuts, but we ended up with ‘higher for longer,’ which has of course hurt other parts of portfolios. But it’s a good reminder that often the positions that feel wrong in your gut can be the most valuable, so having a systematic process as part of a portfolio can provide valuable decision-making diversification.
At quarter end, the portfolio was still significantly short Rates/Bonds, slightly net long the dollar (short JPY vs the dollar and long the Euro), long oil, short gold, and somewhat long equities across regions except EM, which was a small short.
The strategy has proved diversifying, which is the intent, and has been quite beneficial the last two quarters after struggling almost immediately after we added it. We still expect it to be very valuable over time, increasing returns while reducing volatility and drawdowns.
Pg 9 – FPA
The Contrarian Opportunity portfolio fell by about 3% during the quarter, leaving it up over 7% YTD. There was no significant theme to the largest detractors, while the winners were communications focused. It was also nice to see the post-reorg positions in oil services company McDermott International as collectively one of the largest contributors, benefitting from the rise in oil prices.
One of the positions sold was Activision Blizzard, which FPA held since prior to its announced acquisition by Microsoft coming up on two years ago. That deal has obviously been the subject of significant drama throughout its lifespan, and FPA sold the last remaining part of the original position after the positive regulatory development in Q3 that suggested the deal would finally close and caused a bump in the stock price. The deal finally did close subsequent to quarter end.
I won’t rehash the positioning detail here, but the core of it remains generally similar to what it’s been for a while now, with things changing around the periphery in the complementary positions, whether that’s SPACs, other special situations, small private credit positions, etc.
We do note here how credit continues to increase, and a small part of that (so far) is a very minor position in the senior bonds of a stressed CMBS deal where the position has a huge amount of subordination but yields in the low double digits. This is also consistent with a pickup in the portfolio’s exposure to positions either directly or indirectly impacted by the troubles in real estate, both on the equity and credit sides. Cash also increased to about 30%, so the positioning is relatively conservative while beginning to take advantage of areas of dislocation, with a lot of dry powder to potentially take advantage of further trouble.
Pg 10 – Loomis
Although not as high yielding as DoubleLine, the Loomis Sayles portfolio is also very attractive, especially considering its relatively conservative positioning. It’s yielding almost 8% with a duration of about 2 and a half. We didn’t fund any of the overweight to DoubleLine from this portfolio, although it’s a smaller allocation anyway at 15%. Loomis has a larger allocation to corporates, higher cash balance, and significantly less in mortgages, resulting in a lower duration and lower yield.
Similar to DoubleLine, CLO and ABS were contributors, while non-Agency RMBS and CMBS were detractors. Unlike DoubleLine, Loomis had an interest rate hedge in place, although it wasn’t big enough to swing performance dramatically and both portfolio’s were down a bit over a percent.
Securitized credit remains the largest allocation at almost 30%. Securitized and IG are roughly the same as a quarter ago, while net HY exposure is about 6pp lower (a reduction of over ¼ of the position from the end of Q2). HY has come down significantly from several quarters ago as spreads have narrowed by about 100bps over the last six months or so, even though total yield is actually a bit higher at the index level relative to the end of Q1.
One thing I’d note here is that Loomis will typically lean slightly conservative, but has been and can be aggressive in changing exposures when they perceive really strong opportunities. I’ve given this example before, but I think it’s useful in understanding their approach: early in 2020, Loomis viewed the chances to earn excess returns in HY as very low given where spreads were relative to the credit cycle, and they had almost zero net HY exposure. When the pandemic hit, spreads spiked by close to 700bps in the course of about a month to the highest levels since the GFC and by the end of March, Loomis had increased their net HY exposure to almost 50% of the portfolio, actually peaking between 50 and 60%. They finished that year up over 13%, compared to HY ETFs which were up only between 4 and 5% since they had suffered dramatic drawdowns during the early days of the pandemic. I’m not saying we’re going to get that level of opportunity in HY again, just trying to illustrate Loomis will dynamically move their exposures to take advantage of opportunities.
Pg 11 – Water Island
The Water Island sleeve of the fund was up around 2% in Q3 and more than 2% YTD after bouncing back from a few challenging months earlier this year. The portfolio is still heavily weighted toward merger arbitrage, although they will allocate more to other event-driven areas and special situations when they see great opportunities.
The regulatory headwinds have declined, or at least the fear in the investor community related to the regulatory climate has declined, which has caused a narrowing of deal spreads and gains in the space overall. The regulators have lost more than they’ve won, and seem to have been somewhat chastened by this. The big news early in the quarter of course was the US District Court in Northern California denying the FTC’s attempt to block the Activision-Microsoft deal and the FTC’s attempt to appeal was being rejected. That deal closed earlier this month. Amgen and Horizon Therapeutics fought the FTC’s challenge of their combination and the FTC subsequently dropped its case and negotiated a settlement that allowed the deal to proceed. A couple other large notable deals have seen the antitrust review period expire without FTC or DOJ objections, so it does appear to be at least a less harsh environment, even if you still wouldn’t characterize it as friendly by any means.
Spreads have narrowed, but they’re still good. Water Island’s portfolio had a gross annualized deal spread of around 20% at the end of the quarter. Deal volume is still far below the levels it reached in 2020 and 2021, but lack of organic growth in a potentially slowing economy combined with the less aggressive regulatory climate and a levelling off of financing costs could spur a jump in corporate M&A activity. Add to that the huge amount of dry powder that private equity managers are holding (a staggering $2.5 trillion as of mid-year according to S&P Global Market Intelligence and Preqin data), and a big rebound in deal volume wouldn’t be very surprising. That would obviously be beneficial for the strategy.
We saw the clear benefits of this strategy in Q3, as it made pretty good returns while most traditional assets were down. It can of course go the other way, but there is a clear economic return premium that arbs are earning, so over time returns should logically be positive, and relatively independent of the market (absent a dramatic risk-off environment, which does happen periodically).
Pg 12 – Risk/Return Stats
There’s no need for me to read the stats to people, and again, sorry to be a broken record, but I do think we’re near a low point in terms of relative performance compared to the category, as well as absolute terms. We just haven’t rebounded that much off the lows yet. Despite that, the fund is still performing the role a lot of investors use it for in terms of diversifying from core bonds, as it’s outperforming the Agg dramatically since yields bottomed several years ago, and has beaten it by a healthy margin since inception. And as I’ve been saying all year, we think the fund is well-positioned to generate healthy returns from here.
If we oversimplify, the blended portfolio of DoubleLine and Loomis Sayles has about a 9.9% yield to maturity and duration of a little over 4 years. Water Island’s portfolio still offers really good spreads even though they’ve come down somewhat over the last few months. That’s almost 60% of the portfolio with big yields or spreads and a generally harder catalyst-orientation, meaning that there’s healthy current yield and pull to par on the credit side, even if rates don’t change, and deal completions in the merger book. That means we shouldn’t have to wait forever to actually see this potential realized, although it has taken longer to start to play out in any meaningful way than we expected at the beginning of the year. That part of the fund is complemented by DBi and Blackstone Credit, the most diversifying subadvisors in the fund, that have each performed very well during different parts of the year and are each positive YTD. We expect them to generate good returns across cycles, but likely be among the best performers in an economic downturn and when traditional markets struggle. Finally, FPA is the smallest allocation given its high correlation with equities, but it has the highest long-term returns and has performed best so far this year, and it also has the most flexibility to go where there’s dislocation, and a lot cash to take advantage.
So putting it all together, although we’re clearly expecting a lot from credit in the upcoming quarters, there’s a good variety of investment styles and of return drivers in the portfolio, with a lot of diversification benefits from some truly uncorrelated strategies, and a healthy level of dry powder that should allow the fund to remain opportunistic as well. Despite being disappointed by the performance last year and somewhat underwhelmed so far this year, I’m pleased we’ve done significantly better than core bonds. I don’t think I’ve ever been accused of being a wide-eyed optimist, but I’m excited for the fund’s potential going forward.
With that, I’ll turn it back to you, Mike.
I’ll close here by saying thanks to all of our clients and to our prospective clients for your confidence and interest in the iMGP Alternative Strategies Fund. If you have more questions about the strategy, would like further information or a call with us please don’t hesitate to reach out – just send us an email at: email@example.com
Thanks for spending time with us today.
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