2nd Quarter 2010 Commentary
The Fund substantially outperformed the S&P 500 Index, which dropped -11.4%, during the second quarter, though lagged its HFRX Equity Hedge Index benchmark. Nevertheless, the portfolio has outperformed its benchmark for the year-to-date through the end of June, as well as since the Fund's April 2009 inception.
Much of the underperformance relative to the benchmark during the period was attributable to the May 6 "Flash Crash." On that day, the Fund lost 1.3% while the benchmark was down only 0.3%. Note that a full one percent difference on a single day between the portfolio and the benchmark is a highly unusual occurrence, which may have more to do with mark-to-market effects and the potentially delayed pricing of the benchmark's underlying constituents rather than fundamentals.
Strategy Allocations and Performance
As a group, the strategic fixed-income allocations served the Fund well as a source of diversification in finishing the quarter flat. Holdings in this group have tended to be defensive by utilizing macroeconomic hedges and by taking advantage of "disconnects" between fundamentals and pricing, particularly in areas vulnerable to credit problems. Among other credit-related strategies, hedged high-yield came under some pressure as spreads widened in May, but allocations were off for the quarter only marginally.
Not surprisingly, long-biased hedged equity holdings were affected the most by the market downturn, particularly in portfolios oriented towards growth or small-cap stocks. In contrast, merger arbitrage and market neutral strategies were significantly less affected. Although not immune to losses, these strategies tended to provide more stable returns and helped reduce volatility for the Fund overall.
Other macro hedges had mixed results. An opportunistic emerging market trade (short China) was nicely profitable. Conversely, an interest-rate hedge (short US Treasuries) corrected as the flight to safety pushed yields down. We have maintained the latter position due to long-term concerns about massive government debt issuance and potentially rising rates.
Portfolio Positioning and Outlook
In our previous commentary, we wrote that "there are continued signs of economic improvements . . . markets may have become more ebullient than warranted, however. . . As a result, any uptrend will be vulnerable to bouts of significant volatility . . ." In retrospect, our statement may have been "too" prescient, as we did not expect all of the market volatility to be on the downside. Fortunately, the Fund had already reduced its net equity exposure to approximately 30% to 35%. This was accompanied by an increase in hedged credit and strategic fixed-income allocations, which in our assessment had a more attractive risk/reward profile and offered diversification benefits. Subsequently, as downside volatility increased in May, we further reduced both equity and credit-related exposures in accordance with our risk management guidelines, and then re-established allocations during June as conditions stabilized. Net equity exposures remain limited, however.
While before we expected volatility to return, now we wonder if the pendulum may have swung too far in that direction. Markets certainly face serious issues, but key positives seem to have been overlooked: Short-term interest rates remain very low, monetary policy in the US is still accommodative, the corporate sector is flush with cash and earnings continue to surprise on the upside, valuations are not unreasonable, and while China's growth may diminish, that is preferable to overheating.
The last decade began with much discussion about "irrational exuberance." Recent market action may justify a degree of uncertainty among investors, but perhaps we will look back at the current period as one of "irrational pessimism." Overall, we continue to position LASSO to diversify against the risk of conventional asset classes by offering less volatility and reduced correlations, but are poised to make strategic allocations as opportunities for positive returns arise.
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 includes 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. Consult the prospectus for more details.
Past performance does not guarantee future results. Investment return and principal value of mutual funds will vary with market conditions, so that shares, when redeemed, may be worth more or less than their original cost.
Before investing, carefully consider the fund’s investment objectives, risks, charges and expenses. Contact 800 992-8151 for a prospectus containing this and other information. Read it carefully. Aston Funds are distributed by BNY Mellon Distributors Inc.