Q&A With Jason Steuerwalt of Litman Gregory – Part 1

I recently had the opportunity to speak with Jason Steuerwalt, CFA, of Litman Gregory. Jason is a Senior Research Analyst for the firm and has a focus on alternative manager research, and has oversight responsibilities for the managers in the Morningstar 5-star Litman Gregory Masters Alternative Strategies Fund (ticker: MASFX). Prior to joining Litman Gregory, Jason was a Vice President with Hall Capital Partners, focusing on absolute return hedge funds and opportunistic/private credit strategies.

Our conversation focused on a range of topics related the Alternative Strategies Fund, including risk management, manager selection and portfolio construction. Here is what Jason had to say:

Brian: When I look at your fund, it seems straightforward despite being an alternative fund. You have five managers, with Passport Capital being your most recent addition. Each manager has a specific mandate and role in the fund. Is simplicity something that you had in mind when you originally created the fund?

Jason: It is an intentional feature of the fund – we’re generally fans of simplicity if it works and delivers on what we’re trying to achieve. We try to avoid overly optimized, complicated approaches as much as possible. Obviously, we don’t want to oversimplify things, but we wanted to have a relatively small and concentrated group of managers, and I think the simplicity is also reflected in the fact that we have fewer managers and we give them relatively broad mandates within their area of focus.

Q&A With Jason Steuerwalt of Litman Gregory

Jason Steuerwalt, CFA, Senior Research Analyst at Litman Gregory

If we find managers where we have a high degree of confidence in their judgment, it’s better for us to give them more latitude than for us to try to put people in tiny boxes and give them a very tight mandate. That doesn’t give them any flexibility. Thus, we intentionally try to keep it simple and that requires having managers where we have a high degree of confidence in their judgment and decision making.

Brian: That makes sense. In terms of the different investment approaches used by each manager, were those strategies identified up front as ones that would provide the type of diversification you wanted for the fund?

Jason: The big picture idea we started with was, can we create something with a relatively smaller group of managers, compared to a lot of what was out there at the time? We wanted to have fewer managers with a high degree of confidence in those managers to deliver on what they’re trying to do. And then have a group whereby the strategies they run are complementary and different enough, that when you put them together, you’ll get some diversification benefits and not have to have a large group of managers filling every box of alternative investment styles.

So that was the idea. But at the same time, it was never the intent to only have four managers. It was more about creating something we would invest in ourselves and put our private wealth clients into. We felt that if we could do well with four managers, then we could add additional managers and strategies over time if we found managers that meet the high hurdle that we hold for ourselves.

Brian: You mentioned your private client business. Can you expand on how that side of your business played a role in developing this fund?

Jason: Historically, on the private client side, we have had a handful of direct hedge fund investments for our larger clients, but we were interested in finding something similar in the liquid mutual fund world. At the time, the options were limited and many of the funds either had expense ratios that were beyond our threshold or they were unproven strategies. The quality of offerings has improved significantly since the fund launched, but at the time the landscape was somewhat grim.

So, we originally designed the fund for our private clients to invest in, and the fund was seeded with client assets. Their advisory fees were offset against the fund fees so there was no double dipping or conflict of interest. But the idea was to build something better than what was out there, and do it at a reasonable price.

Brian: Moving more toward the investment side of the fund, how is the fund positioned to withstand a potential bear market in bonds should interest rates rise further in 2017?

Jason: That’s a question we get regularly, particularly since two of the managers are associated with fixed income. A couple things I would note is that they both, DoubleLine and Loomis Sayles, have mandates in the fund that are very flexible and quite different from their core fixed income flagship products. Either of them could essentially have zero duration within their mandate for the fund, and they could even have a negative duration, but it’s not something we would typically expect to see.

DoubleLine has been a little bit more active in terms of moving its duration around, but it has always been below the Bloomberg Barclays US Aggregate Bond Index. They have an uncanny ability to be right on interest rate moves more often than not, which is one of their gifts, and we certainly appreciate the fact that they have done it consistently for so long. So they have been a little more active in that area than Loomis Sayles, which has been closer to zero duration throughout much of the life of the fund.

Overall, we’re not taking a lot of duration risk in those fixed income type mandates, but instead are taking more risk on the credit side – at least that’s been their posture so far. If interest rates get back to 5% or 6% at some point, then I would anticipate that they would have significantly higher duration than they have now. But we’re not trying to pigeonhole them into having a specific duration – it’s dependent on where they perceive the better risk-return opportunities. And since inception, the fund has had a slightly negative correlation to the Aggregate Bond Index, so we think that speaks to the flexibility of the mandates and doing something that is quite different than core fixed income.

Brian: When I looked at the statistics related to the fund, I noticed that your beta to the equity market is relatively low, but your correlation is much higher. Is there an explanation for that?

Jason: When we were building the fund, we looked at the track records of the four original managers. Three of the managers had track records that went back to 2000 in strategies that were similar, but not the same strategies that they would pursue for the fund. For the fourth manager, they had a track record dating back to 2005 – again, similar strategy but not the same. When we looked at them all together, and allocated to them in equal parts of 25% each, we ended up with something that went back 10+ years. Over that period, the rolling three-year correlation to large cap U.S. stocks ranged from about 0.3 to 0.7 with an average of a little bit above 0.5. We think that’s probably a reasonable long term expectation in terms of the correlation range, and we’ve been at the upper end of that since inception. Since that is a by-product of the mix of managers in the fund and their mandates, we are not trying to do anything to artificially bring that down.

Another factor that has impacted the fund’s correlation with the equity market has been the credit exposure from DoubleLine and Loomis Sayles. Since the launch of the fund, credit has had a decently high correlation with equities though it’s not equity exposure. When you have a risk-on, risk-off period that characterized a lot of the post financial crisis world, anything with that type of risk exposure, whether it was equities or below investment grade credit, tended to move similarly. Over time, and through different cycles, those correlations shouldn’t be quite that high.

One other thing to note is that going forward, when we’re looking at potential managers to add to the fund, our focus is really on strategies that have lower correlations with equities. Thus, while we have been at the higher end of the 0.3 to 0.7 correlation range, we might see the correlation come down if we go through a different market cycle or add another manager to the fund. Overall, that range is consistent with our expectations for the fund.

Brian: How do you think about your own performance relative to other funds in the multi-alternative category and what do you think differentiates your fund versus others?

Jason: As I mentioned earlier, the category has a lot more high quality managers in it now, and certainly some larger firms that we respect have product available now. The competition is tougher, the category is better, but in terms of fees, I think we are extremely competitive, and in a low yield, low rate environment, that matters a lot. Many hedge funds and liquid alternative strategies have struggled to generate the type of returns that people might have historically associated or expected from hedge funds, and fees matter a lot when the returns just aren’t there.

Another differentiator ties back to your earlier question regarding simplicity. We are trying to find a small handful of managers that we think are really good, where we trust their judgment about when to take more risk versus less risk, or when they’re getting fairly or overly compensated for the risk they are taking, and give them the kind of broader mandate to move things around and take advantage of the best opportunities they are finding. This compares to what a lot of our peers in the category do, which is to say we need to have a long-short equity manager, a long-short credit manager, a macro event driven manager, and on down the list as you fill each category.

That approach sounds good if you’re talking to an investment committee and want to say that you have all this diversification, but that is not the way we choose to approach it. We would rather have a smaller group of managers where we think they will be able to achieve their objectives over time, and the mixture creates a diversified blend of strategies.

Brian: How do you measure and think about risk in the fund, whether at the individual manager level or the total portfolio level?

Jason: We certainly look at risk reports, but I would say we’re not huge believers that they tell us everything we need to know. We do rely to a significant degree on the managers to manage the risk at their level. We can run stress tests and look at the statistics related to each portfolio, similar to the kind of things that everybody looks at. It’s not rocket science, so I don’t think we are adding anything special there. Where we are really focused is on making sure we understand what the managers are doing.

We receive an official monthly report from the managers, and we can look at the portfolios in real time since the managers are all running separate accounts for the fund. We are not typically looking at that every single day, but we are looking at the performance of each manager daily and making sure it seems reasonable compared with what we know they’re doing and what their current exposures are in the portfolio.

If something looks out of line, it might trigger a conversation with a manager based on what we know about the portfolio and what we are seeing in terms of performance. But we try to have more productive conversations that really get at issues that we might not be seeing on just a cursory surface view, rather than just constantly talking to the managers about what is more obvious. In the end, it’s a blend of quantitative and qualitative analysis.

Brian: What types of risk metrics are you monitoring at the portfolio level to know that the fund is on track and performing at your targeted levels?

Jason: We are regularly looking at the volatility of the fund. Since inception, the fund’s volatility has been about 3.4%, which is below our longer-term expectation of being in the 4% to 8% range. But we have been in an artificially low volatility environment with Quantitative Easing (QE) and other central bank interventions. We think over time the fund’s volatility will be somewhat higher that where it has been historically.

We also think about and look at maximum draw downs, because we think that’s a better kind of real life gut feeling. What does it feel like when the markets are down and your fund is down? Drawdown is a better measure of that kind of real world investor experience, so we look at that. And we absolutely look at the cross correlations of the managers within the fund. That has been low over time. Before we added Passport Capital, it was right around 0.1 average correlation between the managers. It’s up a bit since we added Passport, but still fairly low, and something we continue to evaluate, especially when sizing the allocations to each manager or potentially adding a new manager. This measurement is important because we do want the diversification between managers.

Part 2 of this Q&A Session will be published next Monday, May 15.