1st Quarter 2013 Commentary - ASTON/Lake Partners LASSO Alternatives
1st Quarter 2013
U.S. Equity Momentum Rally
The first quarter of 2013 featured a strong, momentum-driven rally in US equities, as the broad market S&P 500 Index gained 10.6%. The index breached its previous closing high of 1565.15 on the final day of March, a level that was last seen more than five and a half years ago just prior to the global financial crisis. Although the new closing high was hailed as an important psychological breakthrough, the more remarkable point is that although the S&P 500 has more than doubled since its low point in March 2009, many investors feel that they have made only slow progress in rebuilding their wealth. Rightly or wrongly, there remains a deep distrust of equities, and there was little evidence of the much-ballyhooed “Great Rotation” from bonds to stocks during the quarter.
There were several notable differences among the market leaders and laggards during the quarter. Relatively defensive sectors, namely Healthcare, Consumer Staples, and Utilities led with gains of 15.8%, 14.6%, and 13.0%, respectively, while the growth-oriented and economically sensitive Technology and Materials sectors were up only 4.6% and 4.8%.
In contrast to U.S. equities, which were supported by encouraging signs of steady though slow improvement in employment and housing, European stocks continued to be plagued by distinctly weaker economic fundamentals, not to mention the banking crisis (and policy debacle) in Cyprus. Consequently, the MSCI Europe Index lagged with a gain of only 2.7% in US dollars (5.5% in euros). Emerging markets did even worse, with the MSCI EM Index slipping 1.6%. Most notably, China fell 4.5% in the face of policy restraint and higher-than-expected inflation. The stand-out among non-US markets was Japan, which jumped 11.6% in US dollars (21.4% in yen) as the new administration pledged aggressive easing.
Within fixed-income, the Fed’s “QE Infinity” was generally supportive of US Treasuries, though the yield curve did continue to steepen modestly. Although the 10-year Treasury yield ended the quarter only slightly higher than year-end, it did flirt with the 2% level several times when investors began to fret about how and when the Fed would eventually unwind its program. Investors’ appetite for yield pushed the high-yield sector higher, while investment-grade corporates came under pressure. In Europe, the European Central Bank’s policy of accommodation resulted in stable yields on Spanish and Italian 10-year bonds. The euro reversed course and weakened versus the dollar, however, especially in the wake of the Italian elections and events surrounding Cyprus. The yen continued to drop against the dollar on expectations of monetary stimulus.
Long Bias Wins Out
The Fund posted reasonable gains during the quarter despite its hedged positioning, though it did lag its gained HFRX Equity Hedge Index benchmark. One reason that the benchmark did better is that many equity hedge funds, as widely reported in the industry press, increased their long exposures, resulting in less hedging. In contrast, the portfolio’s net long equity exposure remained in the range of 30% to 35%. The Fund did maintain its edge over the index for the trailing 12-month period through the end of March, however.
Collectively, the portfolio’s Long Bias and Hedged Equity allocations accounted for the bulk of the Fund’s return. In particular, long biased and opportunistic funds participated most significantly in the market rally, though core hedged equity fund and multi-asset funds had solid gains despite substantial short exposure or cash reserves. The laggards within equities were an Emerging Market long/short equity fund and a value-oriented hedged global fund, but these were relatively small allocations and therefore had a limited impact. Hedged Credit and Strategic Fixed Income allocations generally produced steady, moderate returns. High-yield and mortgage exposures in particular tended to add value.
Elsewhere, the holding in a merger arbitrage-related manager continued to generate relatively stable results as corporate events tended to be more relevant to the portfolio than market action. The convertible arbitrage-oriented manager produced a similarly stable risk/return profile. In the global macro area, the Fund’s underlying manager continued to diversify across a wide range of eclectic sub-strategies in multiple asset classes. Because a number of these strategies are well-hedged and less correlated, the fund had a relatively stable but moderate gain for the quarter.
The Fund’s strategy allocations were largely stable throughout the quarter, the core of which represent a diverse set of equity-oriented allocations accounting for nearly half of the portfolio. Although the allocation to Hedged Credit and Strategic Fixed Income increased marginally from 30% to 32.5%, Arbitrage and Global Macro stayed at roughly 10% and 7.5%, respectively. We did make several changes in manager allocations in each strategy area during the quarter, however.
With equity-oriented strategies representing the largest single allocation in the Fund, it is important to note that this broad category encompasses a diverse mix of long-biased, hedged, multi-asset, and global strategies. We continue to focus our allocations on core managers with relatively more stable risk/return characteristics, and have increased the diversification of the group at the margin by adding a long-biased US hedged equity fund and a long-biased emerging markets hedged equity fund.
Within the fixed-income allocation, we scaled back Hedged Credit from 17% to just under 9%, while increasing Strategic Fixed Income from 13% to 23.5%. This shift reflects the changing opportunity set as well as manager-specific considerations. Part of our “top down” strategy has been to trim high-yield bonds, due to tighter spreads and diminished upside potential, while increasing allocations to more opportunistic and unconstrained funds, especially those with a global approach. Part of our “bottom up” strategy has been to reallocate to funds that are more performance oriented.
The composition of the portfolio’s Arbitrage holdings has been changed by dividing it between merger arbitrage and convertible arbitrage/option hedging. We cut merger arbitrage from 10% to 5%, as the upside of the strategy has been limited due to reduced merger & acquisition (M&A) activity and relatively narrow spreads. We have also focused on a single fund that has been able to add value by emphasizing smaller transactions. The convertible arbitrage/option hedging strategy has tended to exhibit more stable risk/return characteristics than the merger/income fund that it replaced.
Noteworthy within the Global Macro classification is that we have continued to avoid long/short commodities and trend-following strategies as many of the funds in these areas remain out of sync with the markets.
As noted earlier, due to the ongoing potential for renewed volatility in the financial markets, we maintained the Fund’s net equity exposure in the 30% to 35% range. This was supported by the relatively defensive stance of some of the portfolio’s core managers and the continued inclusion of non-equity related strategies.
The pendulum of investor sentiment has swung back and forth between two perspectives ever since the global credit crisis of 2008. The negative side has focused on the debt crisis in Europe, doubts about the resilience of China, and fears of tepid growth and policy paralysis in the US. The positive side has reflected strong corporate earnings, and efforts by central banks to provide stimulus. Year-to-date, equity markets—at least in the U.S.—have demonstrated their ability to trend higher when negative concerns dissipate and positive news predominates.
Will the “pendulum” of market sentiment continue to gyrate back and forth? Most recently, liquidity and momentum have been powerful forces. Nevertheless, market trends can still be interrupted by policy and political uncertainties.
Long-term, the outlook is relatively positive, as the global economy is expected to “muddle through,” corporate cash flows and balance sheets among US companies are strong, and equity valuations generally are fair. Although the first quarter rally in equities is alluring, a measured response is prudent. We therefore are maintaining a diversified mix of equity-oriented, credit-oriented, arbitrage, and macro strategies, with different degrees of correlation and market sensitivity. We believe that the Fund is well positioned to live up to its history of producing attractive risk-adjusted returns over time.
Lake Partners, Inc.
Note: The Fund is a fund-of-funds, and by investing in the Fund you incur the expenses and risks of the underlying funds it invests in. Potential risks from exposure to the underlying funds include the use of aggressive investment techniques and instruments such as options and futures, derivatives, commodities, credit-risk, leverage, and short-sales that taken alone are considered riskier than conventional market strategies. Use of aggressive investment techniques including short sales may expose an underlying fund to potentially dramatic changes (losses) in the value of its portfolio. Short sales may involve the risk that an underlying fund will incur a loss by subsequently buying a security at a higher price than the price at which the fund previously sold the security short.
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