Presenters: Greg Mason, Troy Ward
Hosts: Jeremy DeGroot, Jack Chee, Jason Steurwalt
Date: December 12, 201
Scott Jones: Good afternoon. This is Scott Jones, Institutional Relationship Manager at Litman Gregory. I would like to thank everyone for joining us for today’s webinar.
Our topic today is the recently-launched Litman Gregory Masters High Income Alternatives Fund, and the Litman Gregory Masters Alternative Strategies Fund.
Joining us on the call are members of the Litman Gregory Research team and Ares Management, which is one of the subadvisors of the High Income Alternatives Fund.
Before we begin, I would like to provide a few key points about the High Income Alternatives Fund. The High Income Alternatives Fund seeks to generate a high level of current income from diverse sources, consistent with the goal of capital appreciation over time.
It features skilled, experienced managers running differentiated strategies, focused on non-traditional and less-commonly-utilized sources of income. It draws on Litman Gregory’s 30 years of intensive manager due-diligence, asset class analysis and tactical allocation expertise.
The fund also features an expense-ratio of less than 1%. This collection of managers and their strategies creates a diversified mix of non-traditional income-producing investments, while still keeping an eye on volatility and downside risk.
Today we are joined on this webinar by Jeremy DeGroot, Chief Investment Officer and Partner at Litman Gregory; and co-portfolio manager of the High Income Alternatives Fund, and portfolio manager for the Alternative Strategies Fund.
We also have Jack Chee, Senior Research Analyst and Partner at Litman Gregory, and co-portfolio manager for the High Income Alternatives Fund. And also, Jason Steuerwalt, Senior Analyst and co-portfolio manager for the High Income Alternatives Fund.
We also have, from Ares Management, Greg Mason — managing director and portfolio manager, and Troy Ward — managing director and portfolio manager.
Before we get our discussion going for the High Income Alternatives Fund, I would like to bring on Jeremy DeGroot, CIO at Litman Gregory, to provide some thoughts on the Litman Gregory Masters Alternative Strategies Fund.
Jeremy, the markets have recently begun to experience some increased volatility. Could you offer us some insight into how the Alternative Strategies Fund has handled that volatility?
Jeremy: I’d be happy to, Scott. Thank you everyone for joining us on the call today. We hope it’s informative for you.
I have some comments on the Alternative Strategies Fund. Just to take it from Scott’s question about the current environment, it’s certainly been a challenging year for investors trying to generate positive returns. Most of us on the call have probably seen various references in the financial news recently of the unprecedented breadth of negative performance this year across a wide range of asset classes.
I can cite at least one of those. There was a study by Deutschebank, and they noted that 90% of the 70 asset classes they track were posting negative returns this year. I think this was through late November. That’s the highest percentage in the 100-year history of these asset classes.
This includes global stocks which were down about 3% through the end of November. Investment-grade bonds, which were down about 2%. Treasuries, TIPS, commodities, gold. Almost across-the-board, it’s been a very challenging year.
More relevant to the Alternative Strategies Fund, we can look at the Morningstar Multi-Alternative category return, which was a negative-2.9%. We also look at the HFRX Global Hedge Fund index, which was down 4.9% through the end of November.
Within that context, our Alternative Strategies Fund was down 0.6% through the end of November. And three of our five subadvisors on the fund actually produced positive returns for that year-to-date period, with the other two modestly negative.
While we’re certainly not happy about a flat or slightly-negative absolute-return this year, we accept it when viewed within the broader investment landscape.
We also think it highlights our managers’ risk-management strengths during a period that we can all agree is highly uncertain and potentially high-risk. The fund’s performance during the stock market correction in October and November of this year is consistent with our expectations, and what we’ve communicated to shareholders and investors in terms of the fund’s downside risk potential.
The S&P 500 dropped 10.2% from its high on September 20th to its low on November 23rd. Over the same period, Masters Alternative Strategies Fund lost 2.1%. So our beta on the downside was about 0.2, or 1/5 the decline in stocks.
From the launch of our fund, we’ve tried to communicate this clearly. We said that in a bear market, if stocks are down 25%, it’s reasonable to expect our fund to be down in the mid-single digits.
The performance during this recent market correction is right in line with that expectation. We think that’s important to reiterate.
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Meanwhile, over the longer-term since the fund’s inception, through the end of November, it has gained 4.5% annualized, which compares very favorably not only to its category but to the Agg Bond Index’s 1.95% return, and 3-month LIBOR at 0.7% return.
The fund’s annualized standard deviation was 3.1%, and that compares pretty closely to 2.7% for the Agg Bond Index.
With that history, I’ll move on now to the current portfolio. First, from a big-picture perspective. Several of our managers — and in particular, I’d highlight DoubleLine, Loomis and FPA — remained relatively defensively positioned. Really, waiting for better expected returns to compensate them for taking on more risk within their strategies.
Just as a reminder, we give our managers meaningful flexibility within the construct of their individual investment mandates for our fund, to effectively dial up or down their risk-exposures across multiple dimensions.
We have no doubt that Jeffrey Gundlach, Steven Romick and Matt Eagan will act opportunistically and aggressively to take advantage of compelling investment opportunities when they begin to appear. Which likely will be the result of further substantial financial market price declines.
We’ve seen our managers act this way in the past on our fund, and they all have long track records successfully navigating market cycles and generating strong long-term returns.
As for the other two managers, Water Island currently has a relatively positive outlook for arbitrage and event-driven strategies. And DCI continues to systematically implement its quantitative fundamental long-short credit strategy.
With that big-picture background, I’ll briefly touch on each of the five strategies’ current positioning in a little more detail.
Starting with DCI, as we’ve said, by-construction, the DCI strategy focuses on bottom-up securities selection where they are favoring the bonds of firms that have low default-risk and improving fundamentals, based on DCI’s internal models. They are shorting securities with basically the opposite characteristics.
The environment this year has featured a combination of narrow credit spreads, low-volatility in credit markets, at least until recently, and a notable outperformance of lower-quality credits, relative to higher quality.
Together, these have been pretty meaningful headwinds for DCI’s strategy. Again, we noted they had modestly negative performance year-to-date. But we believe those headwinds and factors are unsustainable. And we’ve seen credit-volatility in particular starting to increase — which should be a positive for DCI’s systematic long-short strategy.
We’ve also spent a lot of time this year digging in more deeply with the DCI team, as to the performance drivers. We expect to see better performance from the strategy as we look out over the next several years.
Moving on to DoubleLine, the Opportunistic Income Strategy continues to perform well. It was up over 3% through the end of November. It’s posted gains during these early volatile days of December, as well.
In terms of its positioning, at the end of the third quarter, non-agency RMBS remains the largest sector-allocation at roughly 53% of the DoubleLine strategy. It’s notable that during the third quarter, Jeffrey Gundlach put a lot of cash to work in sectors outside of mortgages. He and his team established a new position in bank loans at roughly 5%, and they added to CMBS, CLO and ABS holdings, as well.
Overall, the DoubleLine portfolio is yielding — yield-to-maturity — in the mid-5% range. And its duration is just over 5 years.
Moving on to FPA’s Contrarian Opportunities Strategy. It’s been a bumpy year, consistent with what we’ve seen more broadly in the global financial markets.
The strategy was down about a percent through the end of November, and it took a hit in early December, as we’ve seen global stock markets drop sharply. But the FPA portfolio still holds a large cash position on the order of 30% cash. They also had a fair amount of trading activity in the third quarter, establishing some new positions. Liquidating others and adding and trimming to some existing positions.
At the end of the third quarter, the FPA portfolio’s net-long exposure stood at 65%, which was a modest increase from the second quarter. Their largest sector exposure remains in financials, at about 20% of their portfolio. That’s certainly hurt them this year. It’s been a tough sector overall.
We’d also note that about 25% of their portfolio is in foreign stocks.
Moving on to Loomis Sayles and their Absolute Return Fixed-Income Strategy. It’s held up well this year, with a gain of more than 1%. Securitized assets such as ABS, non-agency RMBS and CMBS contributed to positive returns as did Loomis’ position in bank loans and investment-grade corporate bonds.
On the downside exposure to global credits, emerging markets have been a drag on performance this year.
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But the Loomis team has significantly reduced their non-dollar currency exposure as the dollar has strengthened this year. Actually right now their foreign-exchange exposure is the lowest it’s ever been.
Along those lines, their high-yield bond exposure also remains at historically low levels — below 3%. So they’ve really reduced their credit risk as well in the portfolio.
Securitized assets comprised 32% of the Loomis portfolio. Bank loans are 13%. And cash is around 8%.
Overall, the duration of the Loomis portfolio remains quite low, at just around one year. They have a nice yield in the 4.7% range.
Finally with Water Island, their arbitrage and event-driven strategy has produced roughly a 1% gain for the year, with the bulk of those gains coming from the merger-arbitrage piece. At the end of the quarter, their portfolio was close to evenly split between merger-arb-related positions and special-situations positions.
Within their overall portfolio, they tend to bucket or bracket it into merger-arbitrage positions and special-situations. Those are roughly equally split within the portfolio.
Within the equity-special-situations sleeve, it’s well-balanced between long and short positions, both of which they’re looking to generate alpha from.
As I mentioned, Water Island’s outlook for merger-arb remains pretty constructive. They believe global M&A activity will likely continue at high levels, fueled by corporate tax cuts and repatriation of offshore cash by US companies.
However, the obvious ongoing tension between the US and China is a clear reason for caution regarding any global M&A deals that would require approval from China’s regulators. We’ve seen some broken deals this year as a result of that.
Another point to note is that rising interest rates are typically a tailwind of benefit from merger-arbitrage returns. They produce higher spread opportunities for arbitrageurs.
But Water Island knows that rising rates are also a risk for highly-leveraged deals. This is something the team is very sensitive to, and say is reminiscent of some of the excesses that we saw or they saw back in 2006 and ’07.
Just to wrap up my comments, I’ll reiterate that we continue to see each of our managers executing their investment processes with discipline and consistent with our expectations when we hired them for the fund.
We view the recent period of muted returns within the context of the broader market and economic environment. One that has morphed from unattractive valuation and very low volatility in 2017 to something more interesting this year. With market volatility comes investment opportunity; at least for skilled managers such as the ones we’re partnered with.
We really like how the fund is positioned, with plenty of dry powder to be put to work more aggressively at higher expected returns. In the meantime, we expect the fund’s lower risk, all-weather construction to continue to serve a beneficial role in our clients’ and in our own portfolios.
With that, I’ll pass it back to you, Scott.
Scott: Thank you, Jeremy, for that insight on the Alternative Strategies Fund. We will now move our discussion to the recently-launched High Income Alternatives Fund. Jack Chee is a senior analyst at Litman Gregory, and Jack is a co-portfolio manager of this High Income Alternatives Fund. Jack’s going to provide an overview of the Brown Brothers Harriman strategy.
Jack, perhaps before you start on the BBH strategy, you can provide us with some performance data on the High Income Alternatives Fund since its launch.
Jack: Absolutely. Thanks, Scott. Thanks, everyone, for joining the call.
I don’t have too much to talk about with performance in its very short period of just two months. But as Scott pointed out, the fund was launched September 30th, and timing was roughly right before a little bit of market turbulence.
Over the fund’s first two months, what we saw during that period was that equities declined about 7%. High-yield declined about 165 bps and the Agg was down about 21 bps.
In this environment, the fund was down about 1%. While I’d say this two months is an extremely short period of time, the fund has performed how we would expect, which I’d remind everyone the goal is to generate high-yield-like returns with much less volatility than the high-yield market. That’s over a market cycle.
So far, so good.
I’ll just move on to BBH. I think we’re right there on that slide.
BBH is one of two credit strategies on the fund. Their allocation is roughly 1/3 of the fund. BBH runs a credit-value strategy where the goal is to seek attractive risk-adjusted returns across all market environments.
If we flip to Page 11 you’ll see their investment philosophy here. Really in a nutshell, valuations can often disconnect from fundamentals.
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If you apply a disciplined valuation and strict underwriting process, you can really capitalize on the efficiencies that serve us through the broad credit markets.
In terms of process, they are bottom-up investors. It’s a long-term orientation. And their opportunity set, while really broad, tends to focus on non-traditional asset-backed securities, corporate credit, both high-yield and investment-grade. They can selectively invest in some attractive muni bonds, as well.
Within these areas of the market, they tend to focus on rating segments that have historically offered the most-attractive risk-adjusted returns. Within asset-backed, these are single-A to triple-B-rated segments. For corporates, it’s more of that double-B and triple-B segment. Where there’s that line in the sand that separates investment-grade from below-investment-grade.
The reason they focus on these pockets within both segments is that these areas tend to be characterized by strong excess returns, fewer defaults and much lower drawdowns in the event of significant market-declines in credit.
I’d say these segments can also benefit from some volatility that surfaces as a result of rules-based investors. These include both passive investors as well as active investors, who maybe by prospectus or mandate have to stay within either the high-grade universe or the below-investment-grade universe. So when there are upgrades or downgrades, this can create volatility for that specific credit. BBH believes that by layering on active management, you can actually take advantage of some of this volatility, as well. That’s why they tend to fish in those segments.
Regarding credit-selection, we can look at charts — there’s a graph on Page 12. These are the four primary criteria that you’ll see for BBH. Durability, transparency, appropriately structured credits, as well as well-managed credits.
Those are the four main criteria. I’d emphasize durability. We feel that BBH does a significant amount of stress-testing to ensure that a credit will be able to withstand a really wide variety of economic and credit market scenarios.
As for valuation, BBH has a strict criterion. They only invest when they believe there’s an attractive margin-of-safety. One that compensates them not only for default-risk, but also liquidity-risk, as well as the embedded optionality of the bonds.
I’d point out that if they cannot identify these attractive opportunities, they will hold reserves. That’s the case right now.
Wrapping up, I’d say this is considered to be a best-ideas portfolio by BBH. It’s relatively concentrated. We can expect about 75 line items with even fewer obligors.
If you turn to Page 13 there, you can see the characteristics of their opportunity set. That red diamond is the Agg. If you look to the left, you’ll see the non-traditional ABS, the CMBS corporates and bank loans, where they tend to fish.
What you’ll see is the much more attractive yield than the Agg — as well as much less interest rate sensitivity in the form of duration.
I’ll wrap that up; that’s BBH.
Scott: Okay; thank you, Jack.
We will now bring on Jason Steuerwalt. Jason is a senior analyst and also a co-portfolio manager of the High Income Alternatives Fund here at Litman Gregory. Jason is going to review the Neuberger-Berman strategy for us. Jason?
Jason: Thanks, Scott. The Neuberger strategy sells fully-collateralized puts on U.S. equity indexes. The S&P 500 and the Russell 2000.
These are typically about 2% out-of-the-money and average about one month until expiration. The investment collateral in a portfolio of short-maturity US treasuries, in order to generate additional income, and also to somewhat reduce volatility without taking on material interest rate risk.
The options are diversified by strike price and expiration date, in order to reduce path-dependency and manage risk. The team also focuses on capital efficiency by buying back low-priced options in rising equity markets, and recycling that capital by selling new options at higher prices.
This is — big-picture — basically an insurance business. They’re underwriting the downside risk of US equities, but it has a significant deductible if you want to think of it that way, in the form of being 2% out-of-the-money for a one-month option. On average.
We like that this isn’t a strategy that relies on the brilliance of the portfolio manager. Although we do think the team is very strong and thoughtful about adding active management components to a fairly systematic strategy that improves it substantially, relative to a naïve, passive implementation.
It also doesn’t rely on leverage or on complex trade-structuring or tactical market-timing. Those are all features that could be very dangerous in an options strategy.
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Instead, it’s really capturing an insurance premium and capitalizing on investors’ tendency to overpay for downside protection over a full market cycle, as we think the strategy can generate mid- to upper-single-digit returns with mid-single-digit type volatility. It’s definitely an interesting time to launch, as volatility picked up dramatically in October.
Not surprisingly, the strategy was down in that month, but maybe not as much as you might think, due to a few factors. It was down less than 3%, while the S&P was down almost 7%, and the Russell 2000 was down almost 11%.
Those factors being the 2% out-of-the-money, gives you some cushion against market declines. The collateral being held in treasuries gives you a bit of a benefit in a flight-to-quality scenario. And the risk-management that the team employs of buying back some options that are when the market’s going down — redeploying that, to earn significantly higher premiums.
Remember, as the markets fall, the implied volatility increases. Often, pretty dramatically. The premiums increase, and that helps to buffer against losses.
Just to give you an idea of that, as of a couple days ago, the annualized premium you’d receive for selling one-month 3% out-of-the-money puts on the S&P 500 was about 14.5%. For the Russell 2000, it was almost 19%. That’s on 3% out-of-the-money.
So you can see the increased volatility really allows you to earn some significant income when the volatility picks up.
Scott: Okay. Thank you, Jason.
Jack, we’re going to come back to you, now for an overview of the Guggenheim strategy.
Jack: Sure.
Guggenheim is the other credit-manager on this fund. They, like BBH, also account for roughly 1/3 of the allocations of the fund. They, too, like BBH are also seeking attractive risk-adjusted returns across all market environments.
The Guggenheim strategy is unconstrained. You can expect the team to invest across the credit markets and go up and down the credit-quality, and also move across an issuer’s capital structure. Most of the securities you’re going to find in this portfolio will be non-index-eligible. I.e., you won’t find them in the Agg Bond index.
If we turn to Page 17, we can illustrate Guggenheim’s approach, which I define as multi-pronged. This strategy is constantly being evaluated from a number of different perspectives, including a top-down macro view, bottom-up credit perspectives from a really deep and diverse team, dedicated portfolio-construction/risk group, as well as a team of PMs that are always optimizing the portfolio positioning and implementing the trades.
All of these groups are constantly working together to identify the best relative-values, given the current macroeconomic and credit market conditions.
One of the key dials you’ll see Guggenheim turn up and down is their exposure to credit. If we turn to Page 18, you’ll see some broad thematic views on the bottom left-hand side, there. Core defense and opportunistic. Then to the right you’ll see corresponding types of securities for each of those themes.
In opportunistic environments, you’ll see them increase their exposure to credit, and just credit-beta in general. You’ll see more high-yield bonds and loans. You’ll also see them move down in the capital structure.
On the flipside, in defensive times such as now, you’ll see them dial down the credit-exposure and move more into securities with limited spread and duration. Often you’ll commonly see more amortizing securities.
Finally, for Guggenheim, if we go to Page 19, this is a chart that’s similar to what we saw with BBH. You’ll see examples of securities characteristics in their portfolio, relative to the aggregate bond index. Capturing much better yield, with significantly less interest rate sensitivity.
I’d just wrap up by saying we believe this is another best-ideas portfolio from one of our highest-conviction credit managers.
Scott: Thank you, Jack. We’re now going to bring Jason back on to introduce the team from Ares Management. Jason?
Jason: Thanks, Scott.
Before I introduce the PMs on the strategy to talk about it in more detail, I’ll give a quick high-level introduction.
Ares, for those who don’t know, is a top-tier global alternative asset-manager, with approximately 400 investment professionals and over $120 billion in assets under management across a few main areas; namely credit — both liquid and illiquid. Private-equity, including significant investments in energy and infrastructure and real estate.
There are a number of strategies that sit within each of those categories, but importantly, Ares stresses collaboration across the platform, which we think is extremely valuable given the breadth and depth of the firm’s knowledge and experience.
As you’ll hear, Troy and Greg are extremely well-versed in their target areas.
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They operate a fairly unique strategy within Ares that benefits from being inside a firm that’s so active in so many areas of capital markets; particularly private markets.
With that, let me introduce the PMs.
Troy Ward is a managing director and portfolio manager of the Ares Income Opportunity Fund — as well as the similar sleeve that Ares manages for our fund.
Prior to joining Ares in 2016, he was a managing director at KBW and Stifel Financial, where he was a senior equity analyst with a focus on BDCs. Prior to that, he was a senior equity analyst at AG Edwards, where he focused on BDCs, specialty finance companies and smallcap banks.
Troy holds an MBA from St Louis University and he serves on the advisory board for the department of finance at Southern Illinois University, where he received his BS in finance.
Greg Mason is also a managing director and PM of the Ares Income Opportunity Fund and our fund. Similarly, prior to joining Ares, he was a managing director at KBW/Stifel Financial, where he was also a senior equity analyst with a focus on BDCs. Similarly, prior to that, he was a senior equity analyst with AG Edwards, where he covered BDCs, mortgage servicers, asset managers and life-insurance companies.
Greg holds an MBA from St Louis University and a BS from Southwestern Baptist University. He’s also a CFA Charterholder.
Guys, thanks a lot for joining us. Can you start by giving us an overview of the investment strategy and process?
Troy: Great. Thanks, Jason. This is Troy. Thanks for having us on today. We really appreciate it.
If you flip to Slide 25, what this really does is gives a quick overview of the targeted industries in our income strategy. BDCs, mortgage-REITs and MLPs are really the three primary targets. You also have flexibility to get involved in the closed-end funds or other strategic high-income opportunities, should they exist. They’d probably be involved in these if there exists a period of disruption and we have a high conviction on a mispricing in one of those opportunistic areas.
As we think about the BDCs, MLPs and mortgage-REITs, as our bios indicated, Greg and I both have a lot of history in those asset classes. The inclusion of these multiple targeted assets really gives us flexibility to overweight or underweight, based on where we think the best opportunities are available.
We’re actively doing that, of course, within a given industry by our stock-selection, but also within our allocation to each industry group. It will really vary at times widely on how we view the fundamentals within the individual sectors, and the expected economic trends coming on.
Also on 25, regarding these targeted assets, it’s also very important to note that all of these asset classes are areas where Greg and I have a lot of expertise. But also, the broader Ares platform has years of investments and expertise both in intellectual capital and AUM.
If we turn to Slide 26, this is kind of a brief outline of how we think about our investment process. As you start from the top left, Number 1, management analysis and assessment. Greg and I have long believed, and Greg and I have worked together side-by-side since 2005 in a team approach, and we continue that to this day —
Management and analysis is always high on our list. We’ve always said if you can’t trust your manager, you have no business investing with him. That’s something that we’ve taken to heart. We’ve learned in well over a decade of investing in this space.
How management treats its shareholders — what they do — does matter. Historical performance does matter in this part of our analysis, quite honestly. Not just alignment, but —
Depending on how they’re aligned, what do they do with that alignment? There are times when you know you’re not perfectly aligned, but the manager still makes that right choice. Over time, we’ve understood who those managers are that we can trust. We understand there are defensive managers and some that are going to be higher-vol.
The second one we commonly call the MBA-analysis. This is analysis that any investor is going to do. If you’ve had any financial background, this is stuff that anybody can do.
Moving on the third — the bottom-right. The second level. This is really what we’ve figured out over the years investing in this space. This is how we feel we can create alpha in this space.
It’s deep knowledge of the industries that we’re looking at. The high-transparency we get both in the mortgage-REITs and the BDCs and MLPs. Where we can identify the potential upside or potential bad downside of a given asset or group of assets within the companies that we’re investing. That’s definitely an important part of how we manage the portfolio.
Then finally, valuation. Obviously, you take all three of those and you apply what is the current valuation and how much risk we think is already priced in. There can be times where it’s a great company, but it’s priced to perfection. We think there’s more downside risk, even on a great company.
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And vice-versa. There can be opportunities and times where we will say, “Yes. This manager, we’re not willing to put in our back pocket and forget about.” But we also realize when we look at the underlying portfolio and we look at the underlying business trends and look at the valuation and see there’s an opportunity there.
That’s kind of how we think about addressing each one of the different parts of our investment vision.
Jason: Thanks. That’s a helpful overview.
You mentioned valuation, so let’s talk about the current valuations in the areas in which you guys are fishing. A lot of the managers we speak with, as you’ve heard some on this call, are less than thrilled with their opportunity sets. But you guys are refreshingly optimistic. Can you take us through those?
Troy: Yes. We can.
On Slide 28 it’s just kind of a different depiction of the asset classes in blue that we’re focused on. Obviously we are the juice in the portfolio. We are focusing on guys that have very attractive dividend yields.
What’s important is BDCs at 10.2% — the distribution coverage and the trends of distribution coverage. Right now, BDCs have about 109% distribution coverage for that dividend yield that you see there. The mortgage REITs are like 115%, and the MLPs are even higher, at 140%.
Of course, the mortgage REITs and the BDCs earn it and have to pay it out. So you’re going to have a little bit tighter distribution coverage there, whereas the MLPs have the ability — as we’ll talk about a little bit later — definitely of being in the mindset of retaining more capital than they have in the past.
If you flip to Slide 29, looking at the next three slides, it’s the valuation on each individual sector. Slide 29 is the BDCs. This is the price-to-book value. They’re currently trading around 90% of book.
As a group, as you can see, there’s been volatility in the past. But I think one of the things that really sticks out, if you’ve been around this space for a long time, you’ll know that the BDCs’ balance sheet is so much different today than it was all the way back in the Great Recession of 2008/2009.
You have assets that are primarily floating-rate assets, and they’re backed by fixed-rate liabilities. So you have a very asset-sensitive balance sheet that performs very well in this rising-rate. We’ve seen that as LIBOR’s gone higher. We have seen stronger earnings coming out of the BDCs.
Importantly from a credit-quality perspective, we’re seeing good underlying fundamentals in the portfolio. What you have here is a valuation that we believe, as we look at that distribution coverage of 109%, we look at the underlying fundamentals and then we look at the current valuation below book. We think it’s a great opportunity.
I don’t think you can buy this space just carte-blanche, but you do have opportunities within there to pick and choose the good managers at the best valuation.
Slide 30, the same kind of chart. But for the mortgage REIT space. As you can see, the sector is trading at around 98% of book, which is a slight premium to the historic average. But I would say that — similar to BDCs — the balance sheet and distribution coverage is better than in the past.
While we are underweight this sector versus the BDCs and MLPs, which we’ll talk about, we wouldn’t characterize this space today as expensive. We are finding select opportunities. We have capital invested there.
I think as we move into 2019 — and we’ll talk about this a little bit as well — I think this is going to be a space where we probably get more involved as the Fed starts to pause, and things like that.
Then on the next slide, 31, the MLPs again. Similar. They don’t trade on price-to-book. They trade on enterprise value to adjusted EBITDA. Here we go. Just couldn’t get it to update.
This provides where we’re focused. I won’t go into complete thesis on this sector, but I do want to drive home a couple points. We’re focused on the mid-stream MLP assets, which are crucial to the US energy infrastructure.
These are the guys with the pipelines and fractionation plants and other hard infrastructure to get the energy products to the functional user. We’re not investing in exploration companies, energy-field service or salt producers, water or any other much more cyclical and quite honestly more-volatile MLP entities.
The other point I want to highlight is our focus on the underlying fundamentals of the sector.
In 2018, the US surpassed Saudi Arabia and Russia to become the leading oil producer in the world. The US is now a net-exporter in both gas and oil, and the underlying fundamentals of this production are just really compelling.
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The MLP model itself, as you can see in this valuation on this chart — it clearly has been under stress. You’re seeing a transformation in this space that’s really lowering the complexity of better-aligning shareholders with the ability to fund future products, which retain capital, as I talked about before. That high-distribution coverage we have right now.
We are very bullish on this space. We have seen volatility here at the long-term in the sector. We believe it’s one of those times when we want to be buyers. When sentiment is bad, but the underlying fundamentals are good.
Jason: Yes. Before we move on, can you just go into that in a tiny bit more depth? Just to give people a better idea of what you’re talking about with the business model. The evolution of MLPs and how that’s different than four or five years ago.
Troy: Yes. I think the biggest point that we’d want to drive home is with the IDRs and how they used to fund their —
Jason: Sorry to cut you off, but IDRs — for the non-MLP crowd?
Troy: Sorry. Incentive Distribution Rights. That was when the MLPs were first-iteration back in the ’80s and early ’90s — basically as they earned more money, the manager was benefiting by getting a higher and higher percentage of each dollar earned.
There was really this incentive for the MLPs to issue more equity and then drop down a new asset and issue more equity to pay for that asset. That ramped up.
It helped the shareholders as well, because you had increasing distributions, but it really helped the managers.
As we fast-forward to today, some of the biggest changes that we have seen in this space I think are going to be the next generation and what’s going to drive value in the future, once I think investors really understand what they have. The fact that you have the MLP structure changing. You have some converting to C-Corps and getting rid of those IDRs. Those incentives or sharing rights with managers.
But also, as I talked about, the distribution coverage. They’re retaining more capital. So when they drop down and get those new projects to build earnings in the future, they’re not doing that 100% with new equity. So you don’t have that overhang and the fear of, “Well, if they’re going to grow, they’re going to issue new equity.” That doesn’t always benefit the shareholders 100%.
So they’re retaining capital. You’re going to have slower distribution growth in MLPs than you’ve had historically. But you’re going to have much more stable distribution growth and much higher coverage — and I think better valuation in the future.
Jason: Great. Thanks a lot.
With that explanation, can you give us an update on the fundamentals of the asset classes you guys cover, following the most-recent earnings season?
Greg: Sure, Jason. This is Greg.
If you go to Slide 32, you can see there where the earnings have been over the last 12 months. What we’ve seen in the BDCs and the commercial mortgage REITs and the MLPs — they’ve all done very well from an earnings standpoint.
The BDCs last quarter —
We like to look at economic return, which is dividends plus the change in book-value. That tells you what the true fundamental earnings power of the business is.
Last quarter, credit-quality was strong. Book-values were flat-to-up-slightly. The earnings exceeded the dividends. So we had 9.2% annualized economic return.
You can see there in this chart that really, 2018 has been a really solid year from an economic basis. Credit-quality remains strong. The US economy is doing well. Troy mentioned rising interest rates. LIBOR. Because these portfolios are 75% floating-rate assets, LIBOR has actually moved up and improved earnings in the business.
It’s been a very, very strong 2018, and in the third quarter for the BDCs. Similarly for the commercial mortgage REITs, as well. These are REITs that invest in loans backed by commercial real estate, which has been strong.
I would say that the competition in the commercial mortgage REIT space has been very dramatic this year. We’ve seen a lot of spread-compression, meaning lower yields on new assets. That has benefited by being offset a little bit by LIBOR, because they’re also floating-rate. But that has put a little bit of damper on the earnings-growth in the commercial mortgage REITs.
Then as Troy mentioned, the MLPs had a very strong 2018, with all three quarters so far this year over 20% year-over-year EBITDA growth. And now, distribution coverage of 140% — up from 130% last year. Really, using that extra cash that they’re getting to fund new growth projects.
All three of those segments have seen very strong fundamental performance. The one weak point has been the agency mortgage REITs. These are REITs that invest in predominantly risk-free Fannie/Freddie long-dated mortgage-backed securities.
In our strategy, we have avoided the agency mortgage REITs for the past 2.5 years, because of our view the Fed raising interest rates — that’s bad. The Fed unwinding trillions of dollars of mortgage-backed securities would add pressure to that space.
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We’ve seen that really play out in the agency mortgage REIT space, where you can see book-values have declined pretty meaningfully every quarter, and generated a negative economic return this year.
I think we’ll talk about it. I think that trend in agency mortgage REITs might be changing here with what the Fed is going to be doing.
Jason: Can you comment on that? I know there’s a time where you guys might be involved there. What role might agency mortgage REITs play? And when do you think that happens?
Greg: Yes. Agency REITs have always been viewed as a counter-cyclical product. Right? They don’t take any credit-risk. They take lots of interest rate risk.
These stocks do very well when there’s fear in the market. When the Fed is looking to lower interest rates, these become the safe haven play. As a result, they have a relatively low correlation with the rest of the group.
If we look, the agency REITs have a 0.2 correlation with bank loans and a 0.3 correlation with high-yield bonds, BDCs and MLPs. Low-correlation and counter-cyclical.
Our view over the last two years was, we’d seen the economy doing well. You weren’t really worried about credit. And the Fed was raising interest rates. That’s going to be headwinds for the agency mortgage REITs.
I think with what we’ve seen out of the Fed — particularly over the last couple of weeks — with several members of the FOMC walking back the expectations for rising interest rates next year —
I think we’re getting close to the point where we could see the agency REITs becoming a material part of the portfolio, as providing that counter-balance and stability in the portfolio. As the Fed looks to be winding down or slowing the rate of increases, I think it could be a good time to add the agencies back into the portfolio.
Jason: Okay. Interesting.
You’ve touched on a lot of it in those comments, but anything else you want to add about the outlook, going forward?
Greg: I think our view for 2019 — it’s probably going to be a choppy year as the market tries to figure out the economic prospects. The geopolitical issues and what the Fed is going to do. Bottom-line, we think that the credit-quality is still going to be strong in the portfolios. Even if there is some volatility in the equity and debt markets. We think the oil-production that Troy talked about is going to continue to grow at $45-to-$50-plus oil prices. We’ll continue to see growth there.
We can talk about it in a little bit, but I think legislative and regulatory changes in the BDC market are going to be positive for the stocks. We think the fundamentals are going to be pretty positive for all of these groups.
I would say that because there may be some choppy markets next year, we have made sure to focus more on high-quality stocks in the portfolio. If you look at our portfolio today, we’re currently 52% BDCs, 37% MLPs, 6% in the commercial mortgage REITs and 6% in cash, right now. With eyes on being opportunistic with that cash.
We’re sitting at a 9.1% dividend yield on our investments currently in the portfolio.
Jason: That’s a nice juicy yield. Quite a difference from some other areas.
I just want to go back to what you just touched on. The regulatory and business model changes for the BDCs — can you delve into that in a little more detail?
Greg: Yes. There have been some significant regulatory changes that have benefited the BDC space that we’ve been looking forward to for — frankly — years that we’ve been covering it. Last year, Congress changed the limits of leverage that the BDCs can have in their portfolios from a 1-to-1 debt-to-equity ratio to now 2-to-1. So, $2 of debt for every $1 of equity.
While some people have said, “Well, that’s bad timing; you’re adding more leverage right here in this part of the market,” they’re not really adding leverage. It’s giving them cushion to be aggressive if and when there is an economic downturn.
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In the past, the BDC space has generally run close to 1-to-1 debt-to-equity and when there’s weakness in the equity markets, they really have to just be defensive. They can’t add capital to their balance sheet.
The BDCs have all said that with 2-to-1, they’re going to increase their leverage from 0.8 debt-to-equity right now to maybe 1-to-1. That will increase earnings and potentially dividends a little bit next year. It’s also going to provide them lots of opportunity to actually be able to go on the offense, if and when the next downturn comes.
We think that’s going to be a big benefit of both near-term, a little bit of earnings and dividends growth, and long-term being a much more defensive business model.
Second, there is potential for some regulatory changes that will allow the BDCs to get back into indexes. In 2014, the BDCs were kicked out of all the indexes because of a rule made by the SEC. It said if you’re a mutual fund and you bought a BDC, you have to add BDC expenses to your expenses. And other 40-Act companies like REITs were excluded.
The BDCs were a small market when this rule was made back in 2006, and didn’t get that exclusion. They’ve been kicked out of the indexes. The SEC is now very closely looking at changing those rules and giving the BDCs the exemption that the REITs receive.
If that’s the case, we could see the BDCs move back into being in indexes. With all the flows into passive funds, none of that has been going to the BDC space. That’s one of the reasons why the valuations that Troy said —
The BDCs, the MLPs, the mortgage REITs aren’t in a lot of these large indices and have not been seeing the flows go to them. So that could be a material positive tailwind if those rules change and the BDCs move back into the indexes.
Jason: Great.
We all know how important the index flows are, so that’d definitely be a positive.
I want to just go back to the process quickly. As we were talking to you guys, getting to know you, you really stressed management quality as one of the most important pieces of your investment process. You talked about it earlier. Could you elaborate a little bit on why that’s so important to you?
We also know that at times when the valuation discount is appropriate, you’re willing to compromise on that a little bit or potentially take on a little risk with lower-quality assets in a company.
Can you talk about the balance there and how that plays out?
Troy: Yes, Jason. This is Troy; thanks.
Let’s back up to I think it was on Slide 26, if you want to flip back there.
Yes, management is Number 1. We do stress that. It’s been a huge part of our investment process and our thesis in every sector that we’ve worked in for well over a decade.
A lot of that is just living with it. We’ve been in these sectors —
A little more of my background. I started covering the BDCs when there were just two, in 2000. We’ve seen the maturation of the space. I’ve seen all these BDCs come to market. Quite honestly, Greg and I most of the time will know a management team for probably 1.5 or 2 years before they’re public.
It’s kind of a small community, and we get to know a lot of these players because they’re in buying this US-based private-debt and making a portfolio. Eventually they’re going to roll that into a public format. So at some point, we become knowledgeable of them and meet them.
What we’ve learned over time is that the managers —
I’ll back up one step.
A lot of the BDCs — most of the BDCs — are externally managed. In a perfect world, we think, “Oh. We don’t like externally-managed.” But to get the good-quality BDC managers like TPG and David Golub and Apollo and Ares — here internally, they have a very good and big BDC as well —
You’re not going to get those great managers to participate in an internal manner. You just can’t. They’ve got all these other buckets that they’re benefiting from and helping their BDC. You have an external. So now you have an alignment issue. Now you’ve got to find a manager that is saying, “I’m going to run this externally, but I’m going to do right by my shareholders.”
Over the last 15 years, we understand who those players are. Who the guys are that have the good credit-quality, but also maybe there are bumps in the road. This is an investment business and sometimes you make a wrong decision. How do they react?
How do they react with regard to the payments to their shareholders? Additional expenses to their shareholders? Are they “fat?”
That really plays into how we think about when and why we’re going to own a particular investment.
The second part of your question — there are times where we are willing to hold a lower-quality BDC. It’s all about valuation.
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It’s that fourth layer. You have to layer valuation over everything.
I’ll give an example. Prospect Capital. The big BDC. It’s a name that we’ve known since before their IPO. We know that management team well. We don’t really think very highly of them. We’ve seen enough instances over time where they have not done right by shareholders.
They’ve ahead very big wins on the equity side in their portfolio, and those wins always manage to get shielded to where the manager gets a cut of them as basically a capital gain, even though they have a bunch of capital losses they should offset before they get an additional payment. That’s one example of a company that — all else equal, we’re probably never going to hold those guys in the portfolio.
But all else isn’t equal, because the valuation will give us opportunities from time-to-time. The three years that we’ve been doing this here at Ares, Greg and I have owned a little bit of Prospect in different buckets. We’ve traded it and done quite well with it. We can look at the underlying portfolio.
As you know, the BDC portfolios are given every quarter. We can really look into those and feel like we get a good vibe on the underlying credit-quality, and feel where we can own it on a valuation.
Jason: Okay; thanks.
Before we take some questions from the listeners, can you give us a quick example of how you’ve benefited from being on the Ares platform? It’s something that we’ve really liked and talked about a lot, but we’d love to hear it from you guys directly.
Troy: Yes. There’s just a ton of ways. For Greg and me, on the BDC and mortgage REIT side, obviously the platform varies. It’s so wide and so deep. You have energy teams on the private-equity side. Industry teams.
Private-equity isn’t exactly what we’re doing, for sure. But we can talk to their healthcare-energy-sector team. We can understand on what particular spot in healthcare or retail or energy that they’re focused, and where they think there may be an opportunity or credit issue on the near horizon.
On the energy side, I know we haven’t talked a lot about Brian here yet today, but our energy expert on our team — Brian Brungardt — speaks a lot with the energy team at Ares. They have $8 billion to $10 billion of energy infrastructure inside the credit platform here at Ares. Brian definitely taps into those guys with Nate Walton and his team.
We talk a lot with the liquid credit team in New York. We get a biweekly update with Craig on the macro trends they’re seeing in liquid credit. There’s just a lot of opportunity for us to build up a macro thesis.
Then when we identify something in an individual company that we want to learn more about a specific industry or even a specific company, we just have a ton of opportunity to tap into the broader platform here. The intellectual capital has really been helpful.
Jason: Great. Thanks a lot. Apart that. Scott, do we have —
Scott: Yes. We’re going to take questions, now. So if anybody has a question and would like to type it in, we’ll be glad to take that.
To start off, we did already get a question in advance. So I’m going to let Jack take care of that.
Jack: Sure. One of the questions, Scott, was, “How is risk being mitigated by each of the underlying managers?”
I guess maybe Troy or whomever could take that. But at first, I think I’d just give some perspective from the credit managers.
I think an important factor or point I’d want to make is that when we were selecting credit managers, we didn’t want teams that chase yield for yield’s sake. We wanted instead teams with flexible mandates that could protect capital when they think that was warranted. Also, to be much more aggressive when the opportunity set was attractive in terms of being compensated for risks being taken.
That said, both BBH and Guggenheim are very absolute-return oriented. They pay a lot of attention to the risks in the market. But I’d highlight they both probably do it in different ways.
BBH, as I mentioned, is very bottom-up and relatively concentrated. They’re focused on those durable, transparent and appropriately-structured credits that can survive a range of really negative economic or credit scenarios.
The other point I’d make is they’re very focused on valuation. As I pointed out earlier, they’re only investing with an attractive margin-of-safety that is compensating them for default risk, liquidity-risk, and any of the embedded options that are existing in a credit.
Right now just as an example, BBH is keeping with that risk-minded approach. They have a lot of securities that are very short-term in nature. Some investment-grade corporate credits; they’re holding some treasuries. This is all going to be serving as dry powder when the opportunities present themselves.
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Guggenheim has a little different approach. They have a much larger macro input. If anybody’s familiar with them, they’ve been pretty public about their expectations for a recession in the not-too-far-off future. Maybe 12 or 18 months. Somewhere in that ballpark. They’re not trying to be too precise. They’d rather be early than late.
In this environment they’ve been very concerned about credit. Once they have this big macro roadmap, then they start working with the portfolio-construction group / risk-group to establish allocations across credit that under a wide range of scenarios would result in very limited downside. They’re trying to balance that risk-reward.
From there, you have the portfolio management teams working closely with the sector teams to select securities that have those preferred characteristics. I think what you’re seeing right now is them being much higher in credit-quality. They’re much shorter in duration.
You’re seeing them pick up securities that are amortizing. That means it’s constantly kicking off a steady stream of income that can also serve as dry powder during pockets of volatility. If you think back to those charts that we showed for both BBH and Guggenheim earlier, you’re seeing way shorter duration and higher yield.
Hopefully that answers some questions on the credit side.
Troy, if you want to take how you guys mitigate risks, for your sleeve of the portfolio?
Greg: Sure. This is Greg.
When we think about mitigating risks, you’ve got two variables. Protecting principle and then minimizing volatility. I think on the “protecting principle,” we are focused on building a portfolio of solid, high-quality, strong cashflow companies.
We think those are going to protect the principle value of the fund over time. They may have some volatility, but if you focus on the high-quality, good cashflow guys, they will generate long-term strong returns.
Troy talked about potential times when you buy trouble at a right valuation in the portfolio. We don’t have any of those names in the portfolio right now. The entire portfolio is filled with high-quality opportunities.
Trying to minimize volatility, I think it’s adding in some of those agency REITs I talked about. Just having a little bit different allocations across those sectors.
If we look over the past 15 years and you did an equal weighting of BDCs, MLPs and agency REITs, the standard deviation of that portfolio was 20% lower than the standard deviation of any of the individual sectors. I think some of that diversification will help minimize the volatility there.
Jack: Okay. Thanks.
One other question we got was, “What makes this fund unique relative to other alternative income-based funds?”
Jason: I’ll try to tackle that. Not having every single one of those in front of me, some of the big factors are we don’t include dividend/equity common type sectors in here. Like utilities or consumer-staples or even equity-REITs, for that matter. The yields are fairly low relative to the areas that we’re targeting, and oftentimes have quite a bit of rate-sensitivity.
For our equity allocations we want these specialty areas that the Ares team is managing. We think they’ve got a great background there and great information sitting within the overall Ares organization. So we think that’s the area we want to target within equity securities.
The options strategy — other people include various forms of options strategies. I think ours is a fairly pure implementation, as I said, to oversimplify the insurance business without a lot of bells-and-whistles around it, trying to get a pure strategy there. Where we’re really capturing that insurance premium and managing the risk — rather than trying to add a bunch of other pieces on top of it that are going to be doing different things at different times.
The flexibility of the credit managers, where they’ve got really broad mandates — as well as the ability to really dial up or down how aggressive they’re being, based on the valuations they’re seeing. And to shift capital to the most-attractive opportunities.
Really, the breadth of the mandates in terms of going into less-trafficked areas, even within ABS, compared to the more mainstream sectors, there. I think those are the big ones.
01:00:00
As well as expenses, relative to the level of high-quality and really high-conviction subadvisors we’ve got. We try to keep expenses really low.
To me, those are the ones that jump out immediately. Do you guys have anything else to add there?
Jeremy: I think I’d just highlight the — we have the word, “Alternatives,” in the name, because we’re focusing specifically on less-efficient non-traditional areas that are income-oriented.
Clearly, the Ares strategy. BDCs aren’t in indexes. A blatant example. Most people don’t have exposure to them, and you can have an information advantage. They’re less efficient. Then you have managers that have specific expertise in these areas. We think they can generate — at least the strong yields — in more traditional areas with lower volatility or better yield, with comparable risk.
We’ve specifically structured it to complement if you own other income-oriented strategies. It’s a complement to it, or it could be a substitute. We certainly won’t argue against that.
It doesn’t have to be an either/or that you either only own “this,” type of fund. It’s meant to fit within Litman Gregory portfolios. We have other income-oriented investments, and this is a great complement to that.
Obviously these are among our highest-conviction managers or we wouldn’t have partnered with them on the fund.
Jason: Great point.
Scott: We have gotten a question that’s come in. Does anybody want to take a stab at this one?
Jack: Sure.
The question is, “What is the outlook for distributions and what do you think would be reasonable for an investor to expect?”
I think just to start off — you guys please feel free to add what I’ve forgotten. The important thing to add is, we don’t have a specified yield target for this fund. As we talked a lot about with the credit investors, we’d expect them to dial up and down their exposure to risk, given different environments for both either macro or credit markets.
We’d expect that yield number on the credit strategies to evolve over time, or to sway — given the opportunities right now. The opportunity set is getting a little bit more attractive with the pullback, but as they’ve been ramping up, they’ve been pretty conservative.
Both credit strategies have yields in the 4 to low-4s range, and a duration of about 1 year. If you compare that to the Agg of a 6-year duration with a 3.5% yield, we’re getting a yield premium which is a fraction of the interest rate sensitivity.
A lot of the securities in our portfolio are floating. They could benefit from additional rate hikes. They have some characteristics that are amortizing, as I pointed out earlier.
When you combine the 4% yields for those two slugs of the portfolio, and you layer on top of that the Ares and the options income strategy, which are probably in the mid- to upper-single-digits — close to double-digits for Ares —
I think right now on a weighted average basis, you’re getting into the low 5s on a yield basis.
As yields become more attractive, we’d expect this number to increase over time. But I’d say just to reiterate the point we made earlier — our longer-term expectations for this strategy are that we’re hoping to generate high-yield-like returns with much less volatility.
Hopefully that’s helpful.
Scott: Great. Thank you, Jack.
Well, unless someone has another question, I guess we’ll wrap the call up now. We are at 2 o’clock. I would like to thank everyone for taking time out of their day to join us for this webinar. I’d also like to thank the team from Ares management — Greg Mason and Troy Ward — for their time. And also thank our Litman Gregory research team — Jeremy, Jack and Jason — for taking the time out to join us, as well.
We appreciate your interest in our funds; both newly-launched High Income Alternatives Fund and the Alternative Strategies Fund. I would mention that if you have interest in the High Income Alternatives Fund, our research team has put together a great piece. A research background report that’s available on our website. We would encourage you to take a look at that. It has reviews of all of the strategies, as well as the fund, itself.
If you’d like to learn more about either fund or any of the Litman Gregory Masters Funds, please reach out to us at Litman Gregory or visit our website at www.MastersFunds.com.
Thank you, everyone and have a great day.
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