Virtus Small-Cap Value Series
4Q 2016 COMMENTARY
MARKET — Small-cap stocks ended 2016 with a strong finish, surging in the fourth quarter to outpace large-cap stocks for the year.
PERFORMANCE — The Series delivered a strong, double-digit return in the quarter, though underperformed the benchmark largely the result of negative stock selection in technology and energy, and underweight exposure to the financial services sector. Series performance was helped by positive stock selection in producer durables, an underweight position in utilities, and positive stock selection in materials and processing. The top-performing holdings were Primerica and. RE/MAX Holdings.
OUTLOOK — Looking to the year ahead, there is a fair amount of economic uncertainty as the country awaits the arrival of the new administration. If the policy changes put forward by the president-elect come to fruition, we believe the economy and equity markets stand to benefit.
The U.S. small cap market advanced sharply during the fourth quarter. The broad small-cap benchmark, the Russell 2000® Index, gained 8.83%, bringing its year-to-date rise to 21.31%. The fourth-quarter surge pulled small-capitalization stocks ahead of large caps for the year, as the Russell 1000® Index gained 12.05% and the S&P 500® Index returned 11.96% in 2016.
The Russell 2000® Value Index rose 14.07% in the quarter, bringing its year-to-date return to 31.76%. Value stocks significantly outperformed growth in 2016, as the Russell 2000® Growth Index lagged the Russell 2000 Value Index with an 11.32% return. From a value perspective, the top-performing sectors for the year include materials and processing (+62.67%), energy (+43.15%), and technology (+42.24%). The health care sector was the worst-performing sector, returning 4.91%.
The U.S. election was one of the most significant economic events of 2016, as it turned some sector losers into winners, and vice versa. For example, the industrials/materials, energy, financials, and consumer discretionary sectors all increased sharply after the election as investors bet that those sectors would benefit from President-elect Trump’s policies. Other sectors, including utilities, real estate, and technology, have lagged since the election.
For the quarter, the Series returned 12.40% (Class A NAV), compared with the benchmark, the Russell 2000® Value Index, which returned 14.07%. For the full year, the Series (Class A NAV) returned 26.54% and the benchmark returned 31.74%.
The underperformance in the quarter was primarily driven by negative stock selection in technology and energy, and an underweight in the financial services sector. The portfolio’s performance was helped by positive stock selection in producer durables, an underweight in utilities, and positive stock selection in materials and processing.
Positions that contributed most positively to performance during the quarter were Primerica and RE/MAX Holdings.
- Primerica’s shares had been under pressure for the first half of 2016 due to concern regarding how the Department of Labor’s Fiduciary Standard Rule would impact the retirement investment account industry. While the final language of the rule was less onerous than feared, questions remained over the cost of implementation. With the Trump administration expected to drastically reduce federal regulation, those fears have been pushed aside, allowing investors to focus on the fundamentals of the business, which continues to report earnings-per-share (EPS) growth in excess of 20%.
- RE/MAX Holdings increased in the quarter due to strong agent growth and the purchase of independent RE/MAX agencies. We remain confident in RE/MAX’s capital-light business model and its ability to generate superior returns over the long term.
Positions that contributed most negatively to performance during the quarter were Syntel and Monotype Imaging Holdings.
- Syntel again reported weak results with sluggish end-market demand. Management commented that decision cycles continue to lengthen with persistent contract delays. Customer concentration has been an ongoing issue for the company and is a concern from the standpoint of long-term prospects and profitability. Following continued weakness in the business, we exited our position.
- While Monotype’s financial results have been a bit underwhelming, the main driver of the stock decline was the recent acquisition of Olapic, a company that derives its revenue from helping customers leverage user generated content on social media. Investors are likely worried that this acquisition could distract management and damage the long-term profitability of Monotype. That said, the gradual adoption of HTML5 should support results while the company invests in new technologies.
PURCHASES AND SALES
We sold the Series’ positions in Syntel (see rationale provided above) and Village Super Market.
Village Super Market is being challenged by the intensifying competitiveness of the industry, resulting in gross margin pressure and the need to make additional capital investments to maintain consumer traffic. While additional traffic is good, it is not clear whether that will translate long term to higher returns.
As we peer into 2017, we believe there is more than a usual amount of economic uncertainty. President-elect Trump has no public office track record for us to assess and judge how effective he will be in getting changes accomplished. It does seem highly likely that some form of corporate and personal tax reform, partial ACA repeal, increased infrastructure spending, and less regulatory burden for many businesses will occur over the next two years. However, the timing of these changes is unclear. If these events were to occur, we believe the economy should accelerate and grow in the 2.5% to 3.5% range for the next couple of years. We also believe that the S&P 500 EPS growth should pick up from the low single-digit range to the mid-to-high single-digit growth range as economic growth increases over the next year.
The fund class gross expense ratio is 1.41%. The net expense ratio is 1.20%, which reflects a contractual expense reimbursement in effect through 4/30/2017.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains. Net Asset Value (NAV) returns do not reflect the deduction of any sales charges.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The Russell 2000® Growth Index is a market capitalization-weighted index of growth-oriented stocks of the smallest 2,000 companies in the Russell Universe, which comprises the 3,000 largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Limited Number of Investments: Because the fund has a limited number of securities, it may be more susceptible to factors adversely affecting its securities than a less concentrated fund.
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
The investments for the Series are managed by the same portfolio manager(s) who manage one or more of the other funds that have similar names, investment objectives and investment styles as the Series. You should be aware that the Series is likely to differ from the other mutual funds in size, cash flow pattern and tax matters. Accordingly, the holdings and performance of the Series can be expected to vary from those of the other mutual funds.
Shares of the separate Series of Virtus Variable Insurance Trust are sold only through the currently effective prospectuses and are not available to the general public. Shares of the VIT Series may be purchased only by life insurance companies to be used with their separate accounts which fund variable annuity and variable life insurance policies or qualified retirement plans. The performance information for the Series does not reflect fees and expenses of the insurance companies. If such fees and expenses were deducted, performance would be lower.
Please carefully consider a Series’ investment objectives, risks, charges, and expenses before investing. For this and other information about any Virtus Variable Insurance Trust Series, contact your financial representative, call 1-800-367-5877, or visit Virtus.com for a prospectus or summary prospectus. Read it carefully before investing.