Market Sector Update

• With the initial economic shock of the coronavirus pandemic cresting in the second quarter, the market spent the third quarter attempting to sort out when vaccines and treatments would be rolled out, how effective those would be and if and how much incremental government support would be needed. Stocks in turn became driven to a large extent by whether they were considered a reopening stock or stay at home stock and how the incremental news on those key fronts evolved.
• Purchasing Managers’ Indexes (PMI) have rebounded, and inventories are light across many industries, indicating the industrial economy is seeing some recovery and enabling some rebound in employment, though certain areas of the economy are still significantly lagging. While unemployment has been more or less cut in half since the depths of the pandemic, it still remains elevated versus history in the high single digits.
• Relatively large swings in consumer spending patterns have occurred during the pandemic given the hesitancy to spend on services like air travel and hotels and more willingness to spend on goods. This combined with tremendous stimulus and low interest rates has benefitted many consumer durables industries like housing/housing-related and powersports. For example, RH, a luxury furniture retailer, saw roughly an 80% swing in its comparable store sales from -40% to +40% over the course of the pandemic. Additionally, Polaris, Inc., a powersports company, saw tremendous acceleration through the first half of the year, which is something you hardly would expect in a recession.
• While large-cap indices have fully recouped their losses and posted new highs in the quarter, the Russell 2000 Index, the Fund’s benchmark, still sits more than 10% below its 2020 highs as the recovery in earnings expectations has lagged. Volatility continues to be in a heightened state, reflecting the continued uncertainty in the economic outlook and a contentious election season. The large gains off the market bottom seen in the second quarter saw solid continued follow-through in the third quarter with a 4.9% gain, putting it down 8.7% for the year. Looking at the sectors in the index consumer discretionary (+18.9%) led, followed by industrials (+11.0%, and consumer staples (+8.5%) while energy (-9.8%), utilities (-3.2%) and financial services (-2.7%) lagged.
• As mentioned in our prior quarterly letter, a key variable remains how consumers and companies respond when government stimulus wears off and whether this causes economic activity to level off. With many fiscal programs in their current form reaching the end of their life in in the later part of third quarter, the answers will soon become clearer unless further actions are taken. Due to the election, the passing of Supreme Court Justice Ruth Bader Ginsburg, and disagreements on terms it would seem that passing an additional fiscal stimulus package – the fourth in 2020 – has hit a roadblock. In the face of this, members of the Federal Reserve (Fed) have indicated they will keep the federal funds rate tethered to zero for an extended period (several years) all the while continuing to encourage Congress for more fiscal stimulus. As of early October, it remains unclear whether Congress will reach an agreement.
• Where the market heads from here will likely be dependent on further progress being made in the economic recovery (whether it be aided by a vaccine or greater stimulus). Regardless of what happens volatility will probably remain heightened. Even with a potential vaccine around the corner we are of the belief that easier part of the recovery has likely occurred as many of the areas of the market are fairly elevated and reflect optimism. However, we would also not be completely shocked to see the rally continue as Congress and the Fed continue to find a way to pump massive stimulus into the economy and thereby drive a greater appetite for risk. How far this can be perpetuated is an unknown. We believe it would be healthy for the markets to see somewhat of a pause or pullback to digest the substantial move that has already taken place, but little has interrupted the ascent since the mid-March bottom.

Portfolio Strategy

• The Fund delivered a negative return and lagged its benchmark for the quarter. The Fund now is in the third quartile versus peers. Clearly this has not only been a challenging market for us, but also for the small core category, as only 22% of funds have outperformed the Russell 2000 Index.
• The performance of the Fund was entirely driven by stock selection for the period, with sector allocation providing neither a benefit or a detriment. Higher beta and higher leverage stocks performed better in the quarter, continuing the second quarter risk-on rally to some extent, though not with the same magnitude. Given that the strategy tends to favor higher quality and lower beta stocks, the early-cycle behavior of the market continues to present challenges.
• The Fund saw positive attribution from four of the 11 sectors in comparison to the benchmark, with financials, real estate and materials performing the best. The largest detractors were industrials, information technology and consumer staples. The top 20 average holdings struggled in the quarter, creating a 375 basis points (bps) drag on performance. Switch, Inc., TCF Financial Corp. and 2U, Inc. were the biggest detractors, while TopBuild Corp., Generac Holdings, Inc. and First Solar, Inc. provided some positive attribution. Our largest contributors and detractors (those greater than 25 bps or more to attribution) netted to an 80 bps performance headwind in the third quarter.
• Recognizing this recovery is likely to progress we have continued to add greater beta and companies leveraged to a “re-opening” to the portfolio (increased more cyclical names while lowering areas less economically sensitive such as consumer staples and utilities). With that said, the portfolio’s beta still remains lower than the market and we have stuck with a majority of our core holdings. However, we have adjusted to the reality that the economy is on the mend and that some segments of the market are going to see a greater acceleration in growth as the recovery progresses.

Outlook

• We have seen many surprises in 2020, many of which we hope not to experience again. The COVID-19 pandemic has created an environment unlike any we have seen in our careers, and we suspect there are a few more twists and turns in store for us before this is over. We look to learn from this experience and build on it, but firmly believe in the process that has made us successful to date.
• While frustrated, we remain undeterred in our process. We continue to believe that identifying quality, underappreciated companies coupled with thoughtful portfolio construction is a winning formula over time. We fully expect to recover and deliver results more in line with our history as the cycle progresses.

The opinions expressed are those of the Fund’s manager 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, 2020, 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. The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors.

Top 10 holdings as a % of net assets as of 09/30/2020: Switch, Inc. Class A 3.9, TreeHouse Foods, Inc. 3.6, Chemed Corp. 3.4, 2U, Inc. 3.3, Coherent, Inc. 3.0, Knight-Swift Transportation Holdings, Inc. Class A 2.7, Halozyme Therapeutics, Inc. 2.7, Encompass Health Corp. 2.5, TopBuild Corp. 2.4, TCF Financial Corp. 2.3.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty,

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.