Q&A With Jason Steuerwalt of Litman Gregory – Part 2

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. Part 1 of our interview can be found here. The following is Part 2 of this two part interview:

Brian: How are advisors making their allocations to the fund and what role does the fund play in a portfolio?

Q&A With Jason Steuerwalt of Litman Gregory

Jason Steuerwalt, CFA, Senior Research Analyst at Litman Gregory

Jason: It varies a lot depending on the advisor. Typically, we see advisors taking a mixture of stocks and bonds in a conservative allocation, something in the range of 20% stocks and 80% bonds to 40% stocks and 60% bonds, and allocating that to the fund. But there are other advisors that have a more aggressive approach and take a higher percentage from stocks to fund the allocation. In our client portfolios, we generally fund it from that conservative mixture in which somewhere between 20% and 40% will come from stocks and the remainder from bonds.

What we are trying to do when we think about the allocation to the fund is to generate returns that are better than the mixture that the allocation is funded with, and have similar or lower volatility over time with lower draw downs. Keeping up on the return side has been a challenge since the fund’s inception given the equity market’s continued rally, but what we have always said, and we still believe this to be true, is that we may lag during strong bull markets, but over a cycle, and especially in a more normalized environment, we will meet our volatility, return and downside protection targets.

In terms of the role of the fund in a portfolio, we see it as being a core component of an alternatives allocation in a diversified portfolio. Stock and bond exposure is still important to have for various reasons, but adding the fund as an allocation to alternatives helps build out the diversification of a portfolio.

Brian: You started the fund in 2011 with four managers and in 2014 you added Passport Capital. Are you satisfied with the mix of managers you have now, or are you thinking about any more additions?

Jason: We are definitely happy with the mix we have now. We were satisfied with the mix we had prior to adding Passport, and we weren’t explicitly looking to add a long-short equity manager. We happened to find Passport and felt they were very intriguing, then did quite a bit of work on them and felt that they would be additive to the fund – so we added them. And as it stands now, we are fine with the mix of managers that we have, but we’re always looking at new managers that could add something to the fund, not be highly correlated with the other managers, and help improve the long-term risk adjusted returns of the fund.

In terms of additional managers, I wouldn’t be too surprising to see us add another manager this year, but it would likely be a manager that’s running a strategy that’s not long-short equity and has quite a low correlation with equities overall. Over time, I don’t think we would get beyond more than seven or eight sub-advisors. We don’t think it makes sense to have 20 or 30 managers in a fund, and we don’t think there is much marginal benefit beyond seven or eight managers, or something in that neighborhood.

Brian: When you evaluate a manager in your fund, what kind of due diligence are you doing on an ongoing basis?

Jason: We are having periodic conversations with each manager to understand what they’re seeing in the market, where they are increasing or decreasing exposures in certain areas, and how that relates to what other managers are doing. For instance, if two or three managers increased their exposures to a specific area, such as high yield bonds, we would have conversations with them about the risk-return profile of the exposures they are taking and make sure we are comfortable with that.

But again, we are getting monthly reports from the managers, so we are looking at those, talking with them more specifically about any outliers we see in their portfolios, whether it’s performance based or something that isn’t immediately obvious that it would fit into their strategy, so we’re really trying to focus on those types of things. We also receive reports from our operations team, and in those we might see some interesting trades that we didn’t expect. For example, if Passport increased their exposure to a certain industry when they have been negative on it for a while, that might spark a conversation with them about what has changed in their thinking or in their thesis. That’s the type of monitoring we are trying to do, where we have meaningful conversations rather than just checking a box.

Brian: What would raise a red flag for you and result in a manager change?

Jason: Red flags would certainly include portfolio manager changes and performance related issues, but not always. There have been cases historically with other funds advised by Litman Gregory, and these are few and far between but it does happen, where a manager is performing well but for any number of other reasons, they could be removed from a fund. For example, if we get the sense that the manager is not devoting full attention to the portfolio they are managing for our fund. That would be a problem.

But typically, a red flag would be related to performance or personnel turnover on their team. Another issue might be a series of mistakes that are of the variety where it’s the same thing over and over and they don’t seem to be learning and adjusting. Everybody makes mistakes; that’s not necessarily a red flag, but the same thing over and over raises a concern. That is something that may also suggest they may not be paying enough attention to the portfolio.

Another issue that would raise a red flag would be if we are seeing a manager make unusual investment decisions that are way outside their mandate. While we give managers a lot of flexibility within their mandates and within what we think is their area of expertise, going outside of that is a big red flag.

Brian: The allocations to the five managers are not in equal amounts. How did you come up with your manager allocations, and do they change much over time?

Jason: The allocations don’t change very often. When the fund was launched, the strategic weighting was 25% to each manager, and that came from a couple of things. It was looking at the historic returns which I mentioned earlier, and basically taking an equal weighting approach and asking ourselves if that conceptually made sense. We then looked at the historical returns, and it looked quite good from both a return and a risk perspective. So that was the strategic weighting and reflects our goal of not overly complicating things when it’s not necessary, or overly optimizing things based on historical returns.

Interestingly, when the fund launched, the opportunity in non-agency RMBS (Residential Mortgage-Backed Securities) was quite compelling. As a result, we decided to overweight DoubleLine and underweight the other managers equally. We unwound that overweight position in late 2013 and went back to an equal waiting. The idea overall is to have a strategic weighting and not deviate too much from it, and have a high bar for making tactical changes. We haven’t made any tactical changes since then.

When we added Passport, we didn’t opt for an equal weighting because we were at the higher end of where we want the equity market correlation to be, so that argued for not equal weighting. We funded Passport by cutting back on Water Island and FPA since they were the two managers with more of an equity orientation, and we kept Loomis Sayles and DoubleLine at 25% each. The 10% weighting to Passport also acknowledges the fact that we don’t know them as well as the other managers. While we did a lot of due diligence on them, and felt that we know them extremely well, they were not a firm that we had a 10 or 20-year relationship with. Inevitably, there will be things that we learn over time, over the course of hopefully a long and prosperous relationship. If they work out the way we think they will, then they could be a higher weight in the fund. So, overall, that is how we think about the sizing of the managers.

Brian: Going forward, how much change should investors expect in terms of the fund’s investment allocations?

Jason: We wouldn’t expect the fund’s allocation to be dramatically different from one year to the next. Things would change if we add an additional sub-advisor, and we are constantly looking at the mixture of managers, how they interact, where they tend to have more exposure, and their correlation to different markets. But it is a high bar for us to make tactical changes, and we think that is a difficult way to add value consistently.

For example, if we go back to 2015, pretty much everybody agreed that event driven strategies were attractive because mergers, acquisitions and spinoffs were all occurring at extremely high volumes. While that turned out to be right in terms of activity (it was a record year for M&A), event drive strategies really struggled. There were some high-profile deal breaks and deleveraging across the hedge fund space with some forced selling. As a result, there were a lot of bad manager returns in that space that year. So, you could be right on the thesis in terms of what’s likely to be an area of activity, but that doesn’t necessarily mean that the returns from the managers in that space will always coincide with that.

We think it’s tough to add consistent value by forecasting and tactically allocating to strategies look attractive over a short time horizon, and that is why we don’t try to overly optimize the portfolio based on our short-term views.

Brian: That wraps it up. Thank you, Jason. I have enjoyed the discussion.

Jason: My pleasure. Thank you for the opportunity.