Market Sector Update

• The market got its wish for some help from the Federal Reserve (Fed) as policymakers reduced interest rates twice in the quarter. The federal funds target range is now 1.75-2.0%. Inflation expectations softened and growth projections barely budged. This raised concern that conventional policies from the Fed may be less effective this time around.
• Economic headwinds going into the fourth quarter are led by the global trade war and subsequent uncertainty as global supply chains are disrupted. On the bright side, lower rates are boosting housing, the employment picture is solid, and consumer spending has remained resilient.
• The same can’t be said for business, where the outlook darkened in the quarter as uncertainty dampened investment. Global manufacturing hit the skids, with both the U.S. and eurozone toying with a contraction. Global trade slowed and more tariffs are slated for the fourth quarter, which will hit consumers for the first time. Analysts now expect a decline in year-over-year corporate earnings for the third quarter in a row. We don’t see an easy fix and expect continued pressure for the remainder of the year.
• Amid the economic and political uncertainty, real estate stocks have been stalwart performers. The FTSE NAREIT Equity REITs Index, the Fund’s benchmark, was up nearly 8% for the quarter and has delivered a year-to-date total return of 27%, widely outpacing the broader S&P 500 Index.
• Macroeconomic and interest rate conditions remain favorable for real estate operators, although we are paying careful attention to indicators that suggest a slowdown and possible earnings recession in the latter part of the year. If weaker conditions do materialize, we still anticipate solid 2020 earnings growth for real estate investment trusts (REITs) as landlords enjoy the benefit of contractual lease obligations from their tenants and today’s ultra-low interest rate environment is providing a refinancing boost to the expense structure.

Portfolio Strategy

• The Fund delivered a positive return for the quarter, but underperformed its benchmark.
• The Fund’s overall performance for the period is attributed to favorable stock selection and sector allocation across several property types, including office, net lease, regional malls, multifamily and hotel owners. Generally speaking, we have remained tilted toward “defensive” positions within the portfolio given our belief that expectations for a “Goldilocks” environment are too optimistic. We also believe an economic slowdown could manifest itself in corporate earnings declines and continued low Treasury yields. In response, we have increased the Fund’s holdings in net lease and health care while reducing exposure to hotel and retail.
• Stock selection in the office space was the leading positive contributor to the Fund’s relative performance. We have avoided exposure to owners of New York City office given weak operating fundamentals. The recent struggles with failed IPOs only heighten our nervousness about further erosion in that market. The Fund’s positioning in office is primarily tilted to those focused on bio-medical facilities and West Coast owners.
• Net lease owners also contributed positively to the Fund’s relative performance. Net lease REITs are among the most “bond like” real estate property types due to their very long lease commitments and limited rental escalations. Our strategy focuses on the companies we believe have the highest achievable growth potential and it was finally rewarded. We have recently added to the Fund’s weighting in net lease owners given our nervousness surrounding economic growth and it now is overweight relative to the benchmark.
• Retail REITs showed mixed results for the period. Mall REITs lagged the benchmark and were positive contributors to relative performance. Sector weakness was driven by continued concerns about tenant health as well as increased concerns over high leverage at several companies. Shopping center REITs were a detractor from portfolio performance as the group outperformed the index on better than expected results, driven by quicker than expected lease-up of recently vacated space. The portfolio remains underweight both of these sectors with the belief that store closings and leasing costs will remain elevated, thereby muting returns for the space.
• Hotel REITs represent one of the more economically sensitive subsectors. They underperformed the broader REITs group and contributed to relative returns because of the Fund's underweight position. While valuation in the space is starting to look more compelling, we expect new supply, higher labor costs and continued economic headwinds will limit earnings power for the next several quarters and we remain underweight this group.
• The Fund’s overweight position to Datacenter REITs aided performance, but unfavorable stock selection meant the group was an overall detractor on a relative basis. Demand for space remains strong, with the continued enterprise migration, edge and cloud computing, and artificial intelligence expected to provide tailwinds to the group for the foreseeable future. We continue to see the space as attractively valued when considering its growth prospects, and the portfolio remains overweight to this sector.

Outlook

• While the Fed has joined other major central banks in easing monetary conditions, investors are increasingly concerned that the Fed’s toolkit won’t be sufficient when the cycle finally turns. We expect much more discussion about the effectiveness of policy tools. Debate about the merits of fiscal stimulus vs. quantitative easing, negative interest rates and yield curve targeting will keep investors on their toes. Rhetoric going into the 2020 elections also is likely to heighten risk.
• With regard to the current commercial real estate cycle, we continue to see stable operating conditions across the sector with few material concerns on the horizon. Bank lending, commercial construction, equity allocations, and overall pricing metrics remain much healthier than was often the case in previous cycle peaks. However, we are certainly cognizant that real estate valuations have exceeded prior peak levels (although it’s been 12 years since the prior peak was reached). Ultra-low interest rates, continued favorable operating conditions, and dependable cash flows have emboldened investors to see real estate as a relative “safe haven” in today’s environment.
• Private market valuations continue to support REIT valuations, although following the sharp run-up in share prices year-to-date, REITs are now trading slightly higher than their net asset value. This is not an atypical occurrence and is not a source of concern for our strategy. REIT pricing compared to broader fixed income markets also looks attractive compared to historic averages, though in the context of broader equities REITs are more fairly priced compared to historic averages.

All information is based on Class I shares.

The FTSE NAREIT Equity REITs Index is designed to present investors with a comprehensive family of REIT performance indexes that spans the commercial real estate space across the U.S. economy. The FTSE NAREIT Equity REITs index contains all Equity REITs not designated as Timber REITs or Infrastructure REITs. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Because the Fund is generally invested in a small number of stocks, the performance of any one security held by the Fund will have a greater impact than if the Fund were invested in a larger number of securities. Although larger companies tend to be less volatile than companies with smaller market capitalizations, returns on investments in securities of large capitalization companies could trail the returns on investments in securities of smaller companies. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.