Market Sector Update

• The Russell 2000 Index, the Fund’s benchmark, lost 2% for the third quarter and has advanced just over 14% year to date. While it is nice to be up mid-teens, the benchmark is down nearly 13% from its high at the end of August 2018, and has effectively been trading sideways within a range for the past two years.
• While the index was down slightly for the period in an absolute sense, the composition of what drove the returns changed rather dramatically over the course of the quarter, which provided far more volatility under the surface than was exhibited at the index level. More specifically, what drove year-to-date index returns through the end of August were information technology (due to its perceived outsized growth and visibility) while utilities and real estate benefited from rapidly falling interest rates and the comfort of limited earnings volatility.
• Starting in early September, it was like a light switch flipped and those characteristics were no longer embraced. Information technology came under absolute selling pressure, while real estate and utilities lost their leadership position as investors rotated towards higher risk companies within the more pro-cyclical areas of the market that had been laggards such as materials, energy, consumer discretionary and financials. Aside from the pro-cyclical tilt, smaller, higher levered and higher beta names were also the best performers.
• The question going forward is whether this move within the quarter was transitory or the beginning of something bigger, such as a swing from growth to value or a shift to a more pro-cyclical environment. We believe the answer has yet to be determined. While it is not shocking that trends that persist for extended periods of time can always be challenged, especially when valuations become stretched –as the market seems to be suggesting in certain areas, such as subscription-based software– but the abruptness of the shift was definitely a surprise. We also contend that shifting too far towards greater risk/cyclicality at this point in the cycle is not without its own perils with economic indicators still showing signs of deceleration.
• We believe the key to how the market proceeds from here depends on whether growth can reaccelerate meaningfully and show some resilience. Global central banks seem to be doing their part by easing, but until the Federal Reserve becomes more aggressive, the strong U.S. dollar will somewhat counteract these actions. Even with greater accommodation, we believe this will not be enough unless some form of trade deal/cease fire with China is reached as greater clarity is needed to really get businesses to invest once again. Even with a trade deal there are also no assurances, as the impacts of this conflict are still working their way through the system and a deal does not instantly turn on investment. There is also a chance that business activity could further be delayed until after the election becomes clearer which could extend slower growth and further increase the risks of a recession.
• The market also has recently just started grappling with whether President Donald Trump will be re-elected or whether the current Democratic frontrunner, Sen. Elizabeth Warren, will be the next president. With President Trump’s popularity falling, the economy weakening, and the possibility of impeachment proceedings moving forward, the outcome of the 2020 election is looking far less certain than it seemed to be just several months ago. The implications of this uncertainty are great and are starting to work their way into the market as the policy differences between the two candidates could not be more apparent.
• In addition to the political uncertainty in the U.S., it would also seem that the global geopolitical backdrop has become much more challenging. Recent flare ups in the Middle East (attacks on Saudi Arabia’s largest oil complex,) uncertainty over Brexit and political tensions in Hong Kong among other things have potential to also pressure markets and impact future growth trajectories.
• Taking this all into consideration, we are of the belief that taking a more neutral stance towards sector positioning and maintaining a higher quality bias at the stock level is advised until greater clarity arises. Consequently, we have lowered some exposure to some of the more expensive software names, become more in line with defensive sectors and tried to add some exposure to cheaper, higher quality cyclicals that stand to benefit from a trade resolution and an improvement in growth.

Portfolio Strategy

• The Fund delivered a negative return for the quarter, but outperformed its benchmark.
• Across the 11 sectors in our benchmark, we had positive performance attribution in six, with health care, energy and materials performing the best. Five sectors had negative attribution; largest detractors were financials, followed by consumer discretionary and information technology. Across our top 20 average holdings, 14 contributed positive performance relative to the benchmark, contributing just over 150 basis points (bps) to attribution.
• In terms of individual stock performance during the quarter, four holdings contributed to performance attribution greater than 25 bps, and one greater than 50 bps. From a negative performance perspective, six holdings detracted greater than 25 bps, with two holdings detracting greater than 50 bps. The net of these larger contributors and detractors was roughly a loss of just over 100 bps.
• We continue to have a more defensive posture but have broadened our sector allocation to include some cheaper cyclicals while taking down some exposure to technology. We ended the quarter with 60 names, which is at the high end of the range. We look to winnow this down some as greater clarity emerges. As always, we remain opportunistic and we look to take advantage of drawdowns created by volatility.

Outlook

• Looking toward the remainder of 2019, we remain resolute with our view at the end of the first quarter: we wouldn’t be terribly surprised to see the market finish in close proximity to where it ended the first quarter but cover a lot of territory in the process. We welcome being wrong in our assessment and feel like the portfolio could perform under either scenario, but also believe that having reasonable expectations is warranted after experiencing a bull market that is greater than a decade long.
• The choppiness of the market since late 2018, while probably a little extreme, is more likely to resemble what lies ahead than the lack of volatility that has been experienced over the past several years. Aside from being more typical at end of cycles, continued debate about global growth and lack of clarity around a trade resolution, both of which are likely to extend through fourth quarter 2019 and into early 2020, are likely to keep volatility elevated.
• Regardless of how the market performs in 2019, we remain committed to the Fund’s process of identifying quality underappreciated companies, and believe the construction of the portfolio is well balanced so as to perform well versus our peers and benchmark, regardless of the environment over time.

The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Sept. 30, 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. Past performance is not a guarantee of future results.

All information is based on Class I shares.

The Russell 2000 Index is an index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. 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. Investing in small-cap growth and value stocks may carry more risk than investing in stocks of larger, more well-established companies. Growth stocks may be more volatile or not perform as well as value stocks or the stock market in general. Value stocks are stocks of companies that may have experienced adverse developments or may be subject to special risks that have caused the stocks to be out of favor and, in the opinion of the Fund’s manager, undervalued. Such security may never reach what the manager believes to be its full value, or such security’s value may decrease. The Fund typically holds a limited number of stocks (generally 40 to 60). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger number of securities. 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.