Market Sector Update

• The U.S. economy entered 2019 in a position of strength despite high market volatility in the last quarter of 2018. Real gross domestic product (GDP) grew nearly 3% in 2018, and unemployment ended the year near a 50-year low at 3.8%.
• While we expected the economy to decelerate in the first quarter given headwinds of slowing global growth and waning tax reform stimulus, the economy appears to be somewhat weaker than many anticipated. Consensus estimates for first quarter GDP growth have been revised downward to 1.5%. Earnings estimates have been reduced as well.
• The Federal Reserve (Fed) struck an increasingly dovish tone as growth expectations eased, which may translate to a more benign environment for risk assets. Despite a robust labor market, marked by low unemployment and increasing wages, inflation remains lower than expected. In March, Fed Chairman Jerome Powell indicated the central bank sees the current federal funds target rate as neutral and no longer projects further hikes this year.
• Despite a tepid economic outlook, the markets rebounded in first quarter, with the S&P 500 Index producing its best return in 10 years. The real estate sector also was strong as measured by the FTSE NAREIT Equity REITs Index, the Portfolio’s benchmark, which finished the quarter higher than the broader equity index. Macroeconomic conditions remain favorable for the sector, although the current cycle has moved into its 10th year of expansion.

Portfolio Strategy

• The Portfolio delivered a positive return for the quarter, but slightly underperformed its benchmark.
• The Portfolio’s overall performance for the period is attributed to more defensive positioning. Exposures in net lease and health care properties that proved beneficial toward the end of last quarter became a detractor to performance as market sentiment turned in early January. While we remain defensive in our positioning, we have modestly reduced our position in health care companies given the dramatic decline in Treasury yields.
• Office owners were among the best performing real estate investment trusts (REITs ) stocks during the period. Many office stocks entered the year trading at significant discounts to their net asset value (NAV). While operating conditions for these companies remain somewhat challenging, the stock price for many of them represented expectations that were too pessimistic (they became too cheap to ignore, in our opinion.) The portfolio has been overweight office names, particularly those with exposure to California and biotech/life science real estate. We continue to view the growth prospects for select office companies as attractive compared with other REITs, primarily driven by the competition of new developments this year and in 2020.
• Self-storage REITs lagged the broader REIT market in the quarter but with the portfolio’s underweight positioning and favorable stock selection, the sector was additive to performance. Our view on the industry continues to be pessimistic as we see newly delivered supply pressuring revenues for at least the next several quarters.
• Residential REITs remain overweight positions in the Portfolio as we expect steady growth from apartment owners, strong top line growth from manufactured housing companies, and continued outsized demand for single family rental properties driven by increased household formations. After being one of the more additive sectors to portfolio returns during the volatility of last quarter, multi-family returns for the most recent quarter were neutral on the portfolio’s results.
• Hotel REITs, on the heels of significant underperformance in the prior quarter, benefitted disproportionately from the market rebound. The Portfolio was underweight to this sector throughout the quarter, and the combination of negative allocation and selection effects negatively impacted relative performance. We remain underweight the group on concerns that increasing labor costs and continued new supply will pressure earnings, while increasing economic headwinds will pressure sentiment towards the space.
• Retail REITswere a drag on performance in the quarter, as shopping centers, where the Portfolio is underweight, were outperformers, while malls as a group were in line but had a negative stock selection effect. The Portfolio remains underweight to the traditional retail group with the belief that store closings and leasing costs will remain elevated and mute returns for the space.
• Datacenter REITs outperformed the broader index for the quarter but were a drag on the Portfolio’s performance in the quarter due to unfavorable stock selection. Pressures on both development yields and the timeframe to stabilize pressured the performance of our larger overweight holdings. That said, demand for the space remains strong, driven most notably by cloud computing, artificial intelligence, and the continued growth of edge computing. Valuation continues to remain compelling for select names and we are overweight the sector.

Outlook

• Markets recovered well in the period, but risks remain in play, most notably slowing growth and geopolitical issues. The violent tightening of financial conditions last quarter was sobering, so we still are attuned to the potential for volatility. However, we think a strong backdrop for the consumer and friendly Fed policies are enough to limit the downside to the economy.
• 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. Simply moving into the later stages of this recovery does not mean sector fundamentals will turn negative.
• The “bondification” of real estate has been bemoaned by many market participants as irrational, but has become current reality. Short-term REIT price movements have been tightly tethered to changes in the 10-Year U.S. Treasury yield for the past five years. While acquiescing to the new normal, we continue to believe that longer-term share price performance will be heavily influenced by macro conditions. Share price support will come from further employment gains and GDP growth while potentially rising borrowing costs, such as a rising 10-year U.S. Treasury yield, or a steepening yield curve could offer resistance.
• Valuations of private market transactions continue to support REIT valuations, suggesting REITs currently trade at a discount to net asset value, while REIT pricing compared to broader fixed income and equity markets also looks attractive compared to historic averages. Significant fund raising in real estate private equity funds suggests further support for real estate valuation.

The opinions expressed are those of the Portfolio 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 March 31, 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.

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. It is not possible to invest directly in an index.

Effective April 30, 2018, the Portfolio's benchmark changed from the Wilshire U.S. Real Estate Securities Index to the FTSE NAREIT Equity REITs Index.

Effective April 30, 2018, the name of Ivy Advantus Real Estate Securities Fund changed to Ivy Securian Real Estate Securities Fund.

Risk factors: The value of the Portfolio's shares will change, and you could lose money on your investment. The value of a security believed by the Portfolio's manager to be undervalued many never reach what the manager believes to be its full value, or such security's value may decrease. An investment in the Portfolio 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 Portfolio's prospectus. Not all funds or fund classes may be offered at all broker/dealers.

Annuities are long-term financial products designed for retirement purposes. Annuity and life insurance guarantees are based on the financial strength and claims-paying ability of the issuing insurance company. The guarantees have no bearing on the performance of a variable investment option. Variable investment options are subject to market risk, including loss of principal. There are charges and expenses associated with annuities and variable life insurance products, including mortality and expense risk charges, management fees, administrative fees, expenses for optional riders and deferred sales charges for early withdrawals. Withdrawals before age 59 1/2 may be subject to a 10% IRS tax penalty and surrender charges may apply.