Virtus Equity Trend Series
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 Series 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 Series had exposure were underperformers. By the end of the quarter, the Series' financials allocation underperformed the broader sector by nearly 2%. In addition, the Series 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 Series 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 Series — 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.
 Whipsaw: 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
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Effective May 11, 2015, this Series 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 Series’ historic record to illustrate the performance of the new manager’s strategy.
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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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