Virtus Equity Trend Fund
3Q 2016 COMMENTARY
MARKETS — During the third quarter, steadily increasing levels of variability in sector leadership — the persistence of any U.S. equity sector’s performance month over month — added to the challenges that trend-based investment strategies have faced in 2016.
PORTFOLIO — The Fund remained fully invested across all equity sectors during the quarter, including real estate which was added as the tenth sector in September. The high level of variability in sector (and sub-industry) leadership presented issues, specifically a lack of exposure to the leading financials sub-industries, as well as exposure to utilities, which, though underweighted, was by far the worst performing S&P 500® sector of the quarter.
OUTLOOK — In the current absence of sector leadership, we will continue to implement our strategy with the confidence that the momentum risk factor we utilize, when accessed with discipline, has proven to be of great value to investors over the long term.
During the third quarter, the U.S. stock market, as measured by the S&P 500® Index, had strong performance, gaining 3.85%. This headline number managed to conceal some interesting market activity that was happening below the surface at the sector level.
One of the metrics that we track is “sector leadership,” which we define as the persistence of any equity sector’s performance month over month. In normal markets, strong performing sectors tend to stay strong for a reasonably extended period of time, and weaker sectors tend to stay weaker. These trends typically stay in place until there is a shift in the macroeconomic environment that the market perceives to have a lasting impact at the sector level.
Thus far in 2016, we have observed steadily increasing levels of variability in sector leadership, with sectors that were leading experiencing sudden and extreme shifts. For example, in July, energy was the best performing of the GICS® sectors; by September it was the worst performing sector. In August, financials was the leading sector; the next month it was the biggest laggard.
This phenomenon is additional evidence of a stock market that lacks conviction. Combined with our prior observations regarding the unusual frequency of “whipsaw” events and the increased “volatility of volatility,”1 the current state of the U.S. stock market is proving a challenge for trend-based investment strategies.
The portfolio during the quarter was relatively stable, as there were no risk flares that caused a defensive move to cash.
The addition of real estate as an official GICS® sector in September did not have a large impact on the portfolio, as those sub-industries and stocks that were re-classified as part of this sector had already been incorporated into the portfolio models when they were previously classified as part of the financials sector.
The high level of variability in sector (and sub-industry) leadership in the quarter also caused issues in the portfolio. The experience with financials in particular was frustrating. While the sector as a whole was up over 4.5% for the quarter (placing it among the best performing sectors), the sub-industries of the financials sector to which the Fund had exposure were underperformers. By the end of the quarter, the Fund’s financials allocation underperformed the broader sector by nearly 2%. In addition, the Fund had an underweight to the sector, causing the portfolio to miss out on nearly 0.7% of upside potential.
Another challenge during the quarter was the utilities sector. As a whole, the sector was down over the quarter, and even though the Fund had a slight underweight, the steepness of the decline caused utilities to be the largest performance detractor during the quarter.
At the end of the third quarter, the portfolio was fully invested, with exposure to all sectors. We have recently observed a slightly higher than usual number of sub-industries demonstrating weakness. This may be a sign of a narrowing market, and could lead to the portfolio becoming a bit more concentrated going forward. Given the lack of market leadership described above, we can also envision this narrowing trend potentially reversing itself. The uncomfortable fact is that the market environment for most of 2016 has not been conducive to any trend-based investment strategy. In our experience, it is not possible to predict when risk factors — including the momentum risk factor employed by the Fund — will come into, or out of, favor. In other words, risk factors cannot be market timed. Our strategy is systematic in nature, and we will continue to implement the strategy rules with the confidence that over the long term, the momentum factor, when accessed with discipline, has proven to be of great value to investors.
1Whipsaw: A large downward/upward move quickly followed by a rebound or recovery; see “The Realities of Whipsaw Risk" by Rampart Investment Management, Virtus.com, November 14, 2016; https://www.virtus.com/market-insights/blog/Rampart/2016/The-Realities-of-Whipsaw-Risk
Effective May 11, 2015, this fund changed its strategy and its name. The portfolio was fully transitioned to the new manager’s strategy on 5/19/15. Performance since manager change is shown from 5/19/15 in addition to the Fund’s historic record to illustrate the performance of the new manager’s strategy.
Fund class operating expenses are 1.42% and gross operating expenses are 1.55%. Operating expenses reflect a contractual expense reimbursement in effect through 1/31/2017. Operating expenses do not include indirect expenses incurred by the underlying funds in which the Fund invests.
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. POP (Public Offering Price) performance reflects the deduction of the maximum sales charge of 5.75%. A contingent deferred sales charge of 1% may be imposed on certain redemptions within 18 months on purchases on which a finder’s fee has been paid.
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 S&P 500® Index is a free-float market capitalization-weighted index of 500 of the 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 is not available for direct investment.
The Global Industry Classification Standard (GICS®) is a standardized classification system for equities developed jointly in 1999 by MSCI Inc. and Standard & Poor’s. As of August 31, 2016, GICS consists of 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries.
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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.
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.
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.
Allocation: The fund's exposure to different asset classes may not be optimal for market conditions at a given time. Asset allocation does not guarantee a profit or protect against a loss in declining markets.
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