Virtus Strategic Allocation Series
4Q 2016 COMMENTARY
U.S. Equities – 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 surge in the quarter 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. Sectors leading the market’s advance for the full year include materials and processing (+44.34%), energy (+34.10%), and financial services (+31.14%). The health care sector lagged, returning -7.06%. 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, lagged following the election.
International Equities – The reaction in international markets to the U.S. presidential election was mixed, especially in local terms, as a global risk-on market sentiment was combined with a strong dollar rally. The quarter also included a defeat of the Italian referendum vote to reform the country’s legislative process. As promised, Prime Minister Renzi stepped down when his reform effort failed. The winds of change are clearly shifting the focus of U.S. economic policy from monetary toward fiscal, and it remains to be seen whether the EU, U.K., and Japan have the ability and desire to pivot in this fashion. Despite this backdrop, global equity markets proved resilient in 2016. They weathered not only the rocky beginning sparked by China growth fears and dramatic oil price declines, but also a steady stream of global electoral surprises, populist movements, geopolitical events, and positive but not particularly robust GDP growth trends. This result stands in contrast to the previous year, where most markets suffered losses of varying degrees.
Fixed Income – Broad fixed income markets, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, declined nearly 3% in the fourth quarter. U.S. Treasuries tumbled with the backup in rates. Most spread sectors outperformed the benchmark as spreads tightened, and the global demand for yield continued to boost returns. High yield corporate bonds was the best performing fixed income sector. With the exception of healthcare, all industries within the high yield sector had positive results for the quarter, with metals & mining and energy the top performers. On a quality basis, CCC-rated securities outperformed higher-rated credit tiers. Bank loans also generated strong performance, benefiting from a pickup in investor demand. While investment grade corporates outperformed Treasuries, their greater sensitivity to rate movements generated a negative return. The poor performance of emerging markets in the quarter revealed their vulnerability to rising U.S. rates and a stronger U.S. dollar. President-elect Trump’s espoused protectionist policies and their potential impact on trade and other economic lifelines were an additional factor driving cautious sentiment, contributing to a surge in retail fund flows away from emerging markets.
U.S. Equity Allocation – The Series’ U.S. equity allocation underperformed the Russell 1000® Growth Index during the quarter. From a sector perspective, performance was primarily driven by positive stock selection in the health care and financials sector, while performance as hurt by negative stock selection in the information technology and consumer discretionary sectors. From an individual stock perspective, the companies that contributed the most to performance were Netflix and Bank of America. The companies that detracted the most from performance were Facebook and Alibaba Group, the Chinese e-commerce company.
International Equity Allocation – Both sector selection and security selection detracted from the Series' international equity allocation's performance in the quarter, with security selection detracting more. On a sector performance basis, five of the eleven sectors represented in the international equity sleeve made positive contributions to returns, however, the six remaining sectors in the sleeve posted negative returns and pulled the sleeve into negative territory for the period. The materials and health care holdings were particularly challenged, detracting from performance, as did telecommunications, utilities, and real estate. On the positive side, financials, energy, industrials, and consumer staples made positive contributions to the international equity sleeve’s performance.
Fixed Income -- Our underweight sector positions in U.S. Treasuries and agency mortgage-backed securities benefited the fixed income allocation as most spread sectors outperformed the government sector. The corporate high yield sector performed well due to its shorter duration in the rising rate environment and spread tightening during the period. Bankloans benefited from strong technicals, the backup in rates, and tighter spreads. Fundamentals in the asset-backed securities sector remain positive with low unemployment supporting our consumer focus. Although the Fund has a small allocation to the non-dollar sector, the combination of higher inflation expectations and rising U.S. interest rates caused the U.S. dollar to strengthen and, as a result, led non-U.S. dollar securities to underperform. The emerging market high yield sector slightly detracted from performance during the quarter; though fundamentals have shown signs of bottoming, recent geopolitical events reintroduced downside risk. Though exposure to the corporate high yield sector contributed to the overall performance of the Fund, our higher quality bias detracted from returns during a period in which lower quality outperformed.
U.S. Equities – As we peer into 2017, we believe there is more than a usual amount of economic uncertainty. President 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.
International Equities –Headlines suggest that the global economy is on a decidedly expansionary path. Stimulus programs remain in place in the EU, Britain, China, and Japan, while Trump promises fiscal stimulus in the U.S. which would offset the gradual withdrawal of the Fed’s easy money policy. Inflation expectations, particularly in the U.S., are on the rise. China’s growth momentum appears to have improved since the second quarter of 2016, abating fears of a Chinese economic “hard landing” that spooked markets early in 2016. That said, emerging markets in general remain on uncertain footing as the potential for domestic growth is offset by a stronger dollar and concerns regarding FDI (foreign direct investment) to support domestic financing needs. Japan presents an attractive dynamic as higher yields in the U.S. create a flow of funds out of Japan, weakening the yen. The Brexit vote in the U.K. and the presidential election in the U.S. were two events that pollsters got wrong, which should serve to dial up global political uncertainty going forward. Populist movements in the EU will also be put to the test in Dutch and French elections in the first half of 2017, followed by German elections in second half. The future of the EU may hinge on these critical votes. While in our view the macro backdrop has turned decidedly positive, we will remain mindful that investor sentiment is what moves markets, at least in the short run. The resilience of markets in the second half of 2016 was largely attributable to expectations of a favorable outcome to the factors discussed above – accelerating GDP growth, a steepening yield curve, a positive move in commodities, with inflation at reasonable levels. These expectations appear to remain in place and bode well for a continued cyclical expansion in 2017. As a final note, it is no secret that the U.S. has been one of the best performing equity markets the last several years, however, history would tell us that a reversion to the mean is inevitable at some point. Just for comparison, the three-year average annual return for the S&P 500 as of December 31, 2016 is 8.9% while for the MSCI EAFE over the same period the average annual return is -1.6%.
Fixed Income –We are entering 2017 with a fair amount of uncertainty, much of it related to whether and how the newly elected president’s campaign rhetoric will materialize into well-defined policies. Other challenges from 2016 remain as the new year begins. These include the ramifications of divergent global monetary policy; the extent to which the U.S. dollar will appreciate as the Fed tightens; the path of commodity prices; Chinese economic activity and policy; and the ever present but unknown geopolitical risks. Politics has become a heightened dimension of uncertainty as important elections in Europe in 2017 will test the strength of political gains made by anti-establishment individuals and parties. We also enter the new year with renewed optimism for U.S. economic growth, modestly improving credit fundamentals, and evidence of continued albeit slowly improving emerging markets fundamentals. All of these factors should be positive for spread sectors. Trump’s proposed policies are growth-oriented, which implies rising inflation and interest rates. We believe, however, that the Fed will stay the course and let economic data drive monetary policy. While the exact pace and magnitude of future rate hikes is unknown, there is significant evidence to support a gradual rise in rates. This also creates a positive situation for spread sectors. As always, we believe it is important to stay diversified, have granular positions, and emphasize liquid investments. We will continue to look for opportunities in all sectors of the bond market, striving to uncover any out-of-favor or undervalued sectors and securities. We are constructive on spread sectors based on still-sound fundamentals, strong technicals, accommodative central banks, and attractive valuations in certain areas of the fixed income markets. With strong demand for fixed income by investors and a supportive environment, spread sectors continue to offer attractive opportunities to investors searching for total return and yield. Some of the specific sectors where we see value are: out-of-index/off-the-run asset-backed securities, non-agency RMBS, corporate high yield, high yield bank loans, and select emerging market bonds.
Benchmark since inception performance is reported from 9/28/1984.
The fund class gross expense ratio is 1.07%. The net expense ratio is 0.98%, 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.
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: A composite index consisting of 60% S&P 500® Index and 40% Barclays U.S. Aggregate Bond 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 Barclays U.S. Aggregate Bond Index measures the U.S. investment grade fixed rate bond market. The index is calculated on a total return basis. The indexes are unmanaged, their returns do not reflect any fees, expenses, or sales charges, and they are not available for direct investment.
The commentary is the opinion of the subadvisers. 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.
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.
Credit & Interest: Debt securities are subject to various risks, the most prominent of which are credit and interest rate risk. The issuer of a debt security may fail to make interest and/or principal payments. Values of debt securities may rise or fall in response to changes in interest rates, and this risk may be enhanced with longer-term maturities.
Foreign & Emerging Markets: Investing internationally, especially in emerging markets, involves additional risks such as currency, political, accounting, economic, and market risk.
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.
High Yield-High Risk Fixed Income Securities: There is a greater level of credit risk and price volatility involved with high yield securities than investment grade securities.
Prospectus: For additional information on risks, please see the fund's prospectus.