2nd Quarter 2014
The U.S. equity market finished the second quarter with strong gains (with the broad market S&P 500 Index advancing 5.2%), but most of the “pop” occurred during the second half of the period. Indeed, the S&P 500 began April by dropping 3.0% on concerns about the economy, equity valuations, and the situation in Ukraine. Although the market then mounted a solid but uneven recovery as corporate earnings met investor expectations, the index was only up a mere 0.3% by mid-May. It was only from that point on that investor sentiment gathered positive momentum, spurred on by expectations of economic improvement and assurances from the Federal Reserve that short-term interest rates would remain unchanged, even as “tapering” of quantitative easing continued apace. Major global equity indices followed similar patterns, as the European Central Bank and Bank of Japan reiterated their commitment to monetary easing.
Within fixed income, returns were broadly positive for the quarter. Notably, 10-year US Treasury yields trended lower, finishing the period at 2.5%. Yields in Europe also declined steadily, especially in peripheral markets, on signs of improved liquidity and lower inflation. Corporate, High Yield, and Emerging Market credit continued to benefit from investors’ hunger for yield, resulting in tighter spreads.
The Fund posted modest gains during the quarter in outperforming its HFRX Equity Hedge Index benchmark, which was flat, as well as its peer group. For the trailing 12-months, it has slightly outperformed the benchmark while significantly outperforming the peer group. Overall, since its inception the Fund has delivered on its goal of seeking to provide solid returns with less volatility than conventional equity investments. Whereas past performance isn’t a guarantee of future results, annualized standard deviation (a measure of volatility) during that period was roughly one-third the annualized standard deviation of the S&P 500.
Equity-oriented allocations accounted for the bulk of the Fund’s return during the quarter. U.S.-focused funds posted solidly positive results, with one of the portfolio’s core managers outperforming the S&P 500 despite being highly hedged. Global funds had more mixed results, as an Emerging Markets small-cap growth manager was up modestly while a global long/short holding was flat.
Hedged Credit and Strategic Fixed Income strategies were also generally productive during the quarter, led by the portfolio’s core credit-oriented fund. One fund was moderately negative due to its overly defensive positioning.
Arbitrage & Event Driven allocations had little impact, with a merger arbitrage manager down slightly and a convertible arbitrage/covered call manager up marginally due to higher residual equity exposure. The Event Driven fund finished the quarter flat. Finally, the portfolio’s sole Global Macro strategy was up modestly. Its portfolio of diversified and eclectic sub-strategies, which cover multiple asset classes, regained some traction during the last half of the quarter.
The Fund’s net long equity exposure was relatively stable during the quarter, remaining at a level of approximately 39% at the end of June. This level was near the middle of our expected range of 20% to 50%. Overall, we have aimed for a blend of strategy allocations intended to dampen the risk of potential renewed volatility in the financial markets.
Strategy allocations were adjusted only marginally as well, though there were several manager allocation changes. The core of the portfolio continued to a diverse set of equity-oriented strategies representing just under 61% of the portfolio at quarter-end (the same as at the end of March). The combined allocation to Hedged Credit and Strategic Fixed Income strategies increased slightly to 19%. In contrast, we scaled back the Arbitrage & Event Driven category to slightly less than 15%. The allocation to Global Macro remained unchanged.
The most notable changes in underlying holdings came within fixed income. Of the two sub-strategies, we shifted the emphasis toward Hedged Credit as the allocation doubled to 16% of the portfolio by the end of June. This change reflected an increase in the allocation to a core manager in the group as well as a new position in a fund with a highly opportunistic global approach. We reduced the allocation to Strategic Fixed Income from 10.0% to 3.5%, as we sold two positions due to concerns about deteriorating performance and anomalous portfolio holdings.
The Arbitrage & Event Driven category was another area of change during the quarter. Although we doubled the target allocation to an Event Driven fund that follows an opportunistic global strategy to 5.0%, we made a larger reduction in the Merger Arbitrage allocation. We believe that the former has greater upside potential, while the latter has suffered from weakening performance in the face of tighter spreads as well as a few broken deals. The balance of the category is in a convertible arbitrage/covered call fund, which remained at slightly less than a 5% allocation.
There were no changes to manager allocations within the Long/Short Equity or Global Macro categories. Within Global Macro, we have continued to avoid long/short commodities and trend-following strategies, as many of the funds in these areas have been out-of-sync with the markets.
Stocks generally have been “priced for perfection” and expectations of volatility, as measured by the CBOE Market Volatility Index (“VIX”), have declined to historically low levels. Potential risks continue to simmer below the surface, however, including geopolitical conflict, negative economic surprises, and disappointing earnings. Furthermore, the Fed’s policy of tapering constitutes a sea change in that there will be less excess liquidity, which has been so supportive of markets. Thus, even though economic conditions are improving, further progress for equities and risk assets is likely to occur at a more modest pace, with the possibility of greater volatility along the way.
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 LASSO strategy is well positioned to produce 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.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.