Why do you offer the Litman Gregory Masters Alternative Strategies Fund?
The creation of the fund was driven by our own needs as an independent investment advisor managing private client accounts. Prior to the launch of our fund in 2011, we had spent several years researching the public mutual fund universe looking for compelling alternative strategies available at a reasonable cost. We found very slim pickings. Most of the funds we looked at struck us as mediocre, with questionable or unknown manager quality, running unproven strategies based on hypothetical backtested results. They were lacking in transparency and were also charging excessively high fees.
So given our expertise in manager due diligence and running multimanager funds, we decided to create our own fund. We wanted to build an all-weather, lower-risk/lower-beta, core alternative strategies fund—a fund that would be much lower risk than equities, but would also be able to deliver attractive returns over full market cycles. We envisioned a fund with a strong focus on risk management, first and foremost, but also one where the managers and strategies would be flexible and opportunistic. They could potentially take on more short-term volatility when the expected returns and opportunities within their strategies were particularly compelling, but on the other hand, they had the freedom to position their portfolios defensively when that was not the case to preserve capital.
To achieve that type of risk/return profile, we knew we’d have to have high confidence in the managers we selected and their ability to achieve their strategy’s performance objectives. So our due diligence bar was very high in selecting managers. Our objective was to find exceptional investors and risk managers with proven track records that would bring distinct and compelling strategies to our fund—strategies that would have low correlation to each other. So not only are each of the strategies in the fund compelling standing on their own, but when combined in a multistrategy construct you get additional portfolio diversification benefits.
And we wanted to accomplish this at an acceptable level of fees, much lower than what we were finding in the Morningstar Multialternative fund category.
With five years under the fund’s belt, and the top Sharpe ratio in the Morningstar category as of 6/30/2017, we believe we’ve achieved our objectives, so far at least.
Who are the current managers on the fund?
The team at DCI manages a Long-Short Credit strategy. DCI is a San Francisco-based, corporate credit-focused investment firm that manages systematically driven portfolios of long-only, long/short, and net-short credit strategies. At the core of all DCI strategies is a model that uses publicly available information from credit, equity, and options markets to calculate default probabilities for hundreds of corporate debt issuers, and then translates the default probability into a corresponding "fair value" credit spread. DCI then compares their model-generated credit spreads to the actual credit spreads in the market and buys the most undervalued credits and shorts the most overvalued credits. The strategy’s portfolio will consist of two components: (1) A long-short, market neutral portfolio comprised entirely of single-name, corporate credit default swaps (CDS). This sleeve will contain 70-100 positions on each side of the book, and will be approximately 100% long and 100% short on a notional basis. Returns are expected to come from both longs and shorts as the market credit spreads converge toward DCI’s fair value modeled spreads. Because the portfolio is balanced across different risk factors (e.g., sector, geography, etc.), the returns should be almost exclusively driven by credit selection. (2) A portfolio of approximately 70-100 high yield cash bonds hedged with CDX (the high yield CDS index) and Treasury futures to reduce credit beta and interest rate risk, respectively. The hedging should largely isolate idiosyncratic credit risk as the main driver of performance. We believe the strategy can produce annualized positive returns with very low correlation to equity markets, credit markets, interest rates, and to the fund’s other subadvisors.
Jeffrey Gundlach of DoubleLine Capital is running an Opportunistic Income strategy for our fund. This is substantially similar to a very successful private partnership strategy he has run for the past 25 years, first at TCW and now at DoubleLine. Gundlach describes the Opportunistic Income strategy as his “best ideas fixed-income” portfolio. It’s very important to understand that this strategy has a much higher return objective than his well-known DoubleLine Total Return Bond mutual fund strategy. He’s looking to outperform the Bloomberg Barclays U.S. Aggregate Bond Index by several percentage points annualized over the long term (an objective he’s more than met so far), with maximum volatility of around 8%–9%, so a much higher expected return and higher risk than his core bond mutual funds. The strategy has a flexible mandate in terms of duration and sector exposure, and will invest across fixed-income markets but with a particular focus on the mortgage sector, which is where we believe DoubleLine has particular expertise and a demonstrated research edge, enabling them to construct portfolios with superior risk and return characteristics. Gundlach may also use a moderate amount of leverage in his Masters portfolio (up to 30% of net assets), which is consistent with how he runs the private partnership.
Steven Romick and his team at FPA are running a Contrarian Opportunity strategy. FPA is a firm we have invested with for more than 15 years, including Steve Romick’s hedge fund. They are contrarian and risk-averse investors who invest across the capital structure and across asset classes, market caps, industries, and geographies. It’s really a go-anywhere strategy—it all depends on where the value is. They will also short stocks, sell options, and own some less liquid investments in our portfolio (e.g., commercial real estate lending, residential mortgage loans, farmland partnerships). They are long-term investors and will hold cash if they can’t find enough investment ideas that meet their absolute-return hurdle. Their objective is to generate equity-like or better returns over the long term with much less risk and avoid permanent loss of capital. Romick has been running similar strategies for more than 15 years in both private and public funds. The portfolio he runs for our fund is sort of a hybrid of his hedge fund and mutual fund strategies. We think he and his team are among the best absolute-value, bottom-up stock pickers we have researched. They execute very deep fundamental research and are extremely disciplined and patient in executing their approach, which has led to great long-term returns for their investors (both in absolute and risk-adjusted terms). Our investment mandate and small asset base gives the FPA team more flexibility than they have in their own public fund, enabling them to take more concentrated positions in their highest conviction ideas and own less-liquid or smaller companies.
Matt Eagan and team at Loomis Sayles are running an Absolute-Return Fixed-Income strategy. Their goal is to generate attractive risk-adjusted returns significantly above 3-month LIBOR over a full market cycle and with relatively low volatility and low correlation to equities and credit. The team draws on Loomis’s large global research team and combines top-down macro analysis with bottom-up company research and security selection. They look to add value by positioning across what they call “the three Cs”: curve, credit, and currency. The strategy will also use derivatives to gain exposure and to hedge risk. For example, they may have long positions in individual high-yield bonds that they believe are fundamentally undervalued, and then hedge some of the overall high-yield beta by shorting the high-yield CDX index. Or they may have exposure to foreign currency bonds and then hedge out the currency exposure. And they will short Treasury futures to manage the overall portfolio duration. They have wide latitude in terms of their overall long and short exposures. Their mandate for our fund also gives them wide flexibility in terms of their non-dollar, high-yield, and emerging-market exposure, as well as in terms of their duration or interest rate exposure. The managers analyze and manage their risk exposures and return potential over both short-term and longer-term time horizons. And while they manage pretty tightly to their risk objective, like all our managers, they will vary their risk-taking depending on the environment and the opportunity set.
John Burbank of Passport Capital is running a global Long-Short Equity strategy for us. Passport has been around since 2000 and until 2014 had only managed private funds. But they have adapted their long-short hedge fund strategy for the mutual fund space. In our view, Passport brings to the table a unique combination and integration of three core areas of expertise: (1) macro research and thematic positioning; (2) strong fundamental industry- and company-level research; and (3) quantitative portfolio construction, risk analysis, and risk management tools. The team develops a number of macro themes, while the individual sector analysts and portfolio managers conduct intensive company and industry research to find the best ways to express those thematic views. Their analysts also search for idiosyncratic, company-specific investment ideas. The quant piece then focuses all the themes and individual ideas into a thoughtfully constructed portfolio that balances the goals of high absolute returns while controlling risk. Their performance objective over a market cycle is to generate returns in the low double digits with comparable volatility. Their long exposure should be in the range of 70%–100% and their short exposure should be in the 25%–40% range. Expected beta may range from 0.2 to 0.7, depending on how attractive the expected returns are. They will invest across the globe and are focused on liquid mid- and large-cap stocks (greater than $5 billion market cap).
Finally, Water Island Capital is running a Merger Arbitrage and Event-Driven strategy. In addition to traditional equity-oriented merger arbitrage, they also invest in credit merger arbitrage, and other event-driven opportunities in both equities and credit. The strategy tries to profit from a variety of different corporate actions or events, with the goal of capturing company-specific returns that are not necessarily correlated with the overall market direction. In addition to traditional mergers and acquisitions, examples of events and catalysts include management change, corporate refinancings, spinoffs, and restructurings. Our portfolios are getting their highest-conviction (highest-risk-adjusted return) ideas from across their event-driven and arbitrage strategies. They manage risk very carefully, and they also have the ability to utilize moderate leverage in their portfolio for our fund. Our return expectations for the strategy are in the mid- to upper single digits with low volatility and low correlation to traditional market indexes.
Importantly, each manager is running a distinct separate-account portfolio for our fund. This is not a fund of funds that you could construct on your own.
What role do you see this fund playing in a portfolio?
We view the fund as a core, lower-risk alternatives holding within a diversified balanced portfolio. In our own client accounts, it replaces a mix of traditional stock and bond investments. Depending on the client’s risk tolerance and portfolio objectives, we fund a position in the fund from a mix of around 20%–40% stocks and 60%–80% bonds. We think our fund should have comparable risk and volatility to that type of stock/bond mix, but we believe it can generate better returns and also add beneficial portfolio diversification.
Do you monitor each strategy for performance, style integrity, and other factors?
Yes. At the most micro level, we have daily transparency into each manager’s portfolio and performance. Now we’re obviously not basing decisions on daily performance, but it can sometimes give insights or raise questions about their portfolio positioning and risk exposures during particularly volatile market days. We also get their portfolio trades on a daily basis from the fund’s custodian—the managers execute all their own trading. However, our focus here is much more on a monthly basis—seeing how the managers’ portfolio positioning has or has not changed, what they have been buying and selling. We don’t look at the daily trades unless there is a sharp market dislocation that may lead them to make significant changes quickly.
Each month the managers also send us various summary portfolio statistics, exposure breakdowns, and performance attribution, so we have transparency into each managers portfolio. On a quarterly basis, the managers prepare commentaries for us discussing the key drivers of their performance, winners and losers, positioning and outlook.
In addition to the portfolio data, we have frequent interactions with our managers via email and/or phone throughout the year. In addition to these one-off interactions and contact, we typically will do one or two formal update calls or meetings with our managers each year to walk through their portfolio positioning, outlook, risks, etc., in detail. Managers will often come by our office to meet with us when they are in the San Francisco area. And we will visit them in their offices as well.
We have built strong relationships with all our managers, and we know they respect the depth of our due diligence and research process, so access to them is not an issue.
What would favorable and unfavorable market conditions for this fund look like?
The fund is diversified and actively managed. By design it should not be heavily dependent on broad stock or bond market conditions for its long-term success.
It’s hard to generalize, but we’d expect the fund to perform well in both absolute and relative terms in an environment of rising rates (where traditional bond funds are doing poorly) and a weak equity environment, for example, where there is not a strong market tailwind from rising price-to-earnings multiples. In other words, our fund isn’t dependent on falling rates or rising valuations to drive returns.
The fund will likely look like a laggard versus a pure stock fund when we are in the later stages of a bull market, as our more equity-oriented managers may be more defensively positioned because they see high valuation risk and downside risk. That has been the case in the past few years, for example with FPA and also Passport.
But if and when riskier assets sell off sharply, our managers have the ability and mindset to increase their exposure with the expectation of generating high returns—we saw that recently with Loomis Sayles buying into the selloff in energy high-yield bonds, for example. That hurt their performance over the short term, but overall it has been hugely positive for the fund. We also saw that with DoubleLine’s purchases of non-agency mortgage-backed securities after that sector plunged during the financial crisis, selling at cents on the dollar.
Again, we view the fund as a core, all-weather, lower-volatility, lower-risk holding, but one with the potential to generate attractive returns over time. But it will be dependent on the opportunity set. We are very confident in our managers’ skill and discipline and that they will not reach for returns.