Changes in global stock fundamentals may offer new opportunities
- We expect the Fund to hold a broader allocation of equities instead of more concentrated portfolio of recent past.
- Correlations have fallen and markets are starting to differentiate among securities again.
- We think continued low interest rates will make it difficult to achieve gains in Treasuries.
Entering 2013, the Waddell & Reed Advisors Asset Strategy Fund held a heavy weighting in U.S. and foreign equities. That weighting was similar to the Fund’s positioning since about the second quarter of 2010. Changing equity market fundamentals as the first quarter got under way have caused us to begin adjusting our approach to asset allocation while maintaining that focus on equities.
Positioning for the future
We have slightly reduced some of our equity positions and, correspondingly, the Fund’s cash position has increased somewhat. We expect some of that cash will be re-invested in a somewhat broader allocation of equities, rather than in the more concentrated positions that we have held over the past year and a half.
We think this adjustment in our approach will reduce stock-specific risk and will put our focus on country risk, sector risk and the systemic risk of equity markets overall. As a result, we expect the Fund will have a more diversified, more global portfolio over time. We believe this is an appropriate positioning for this point in the current credit cycle.
We think the global economy is progressing through a robust credit cycle — meaning getting closer to the time when interest rates eventually will begin to increase, although that still may be a year or two in the future. We remain concerned that policy makers have used so many tools to re-inflate asset prices and fix credit problems but have not restructured the global debt problem overall.
Building the portfolio
In the post-2007 environment, we periodically have seen correlations among stocks hit peaks not reached since the worst of the Great Depression and then fall to “lows” well above the levels from the 1940s until 2007. As we noted during the third quarter of 2011, we saw high market volatility, high levels of correlation and equity risk premiums1 at historically high levels. In our view, that was a time to focus on individual stock selections. We wanted to take active equity selection risk because we did not believe the market was correctly pricing equities, especially relative to fixed-income securities. The Fund therefore was highly focused on individual global equities and held a concentrated, high-conviction portfolio.
We now believe the market is markedly different. Correlations have fallen and markets are starting to differentiate among securities again. As we look to the future, we intend to reposition the Fund over time from being concentrated, with relatively few individual equity holdings, to being more diversified and holding more names.
Given our view on global equity markets, we now are seeking broader equity exposure — much as we did in the Fund during 2006-07. We believe the current market requires a similar approach.
The Fund has some exposure to credit, and we have added a short position in U.S. Treasuries. We do not expect deflation in the U.S. economy and believe that continued low interest rates will make it difficult to achieve gains in Treasuries prices. The short position also reflects in part our analysis of the behavior of gold and Treasuries, and our expectations for government policy makers.
We think investors have been treating gold as a safe asset, rather than as a hedge against inflation. If significant inflation were to develop in the U.S. economy and interest rates were to rise, we think Treasuries would not do well and gold may not do well, either. If U.S. policy makers instead were to introduce economic stimulus again, we think Treasuries would do well and gold prices would be fine. Thus, in a sense, our strategy pairs these investments.
We believe it is likely that policy makers will be late to raise rates, so the small short position on longer-dated Treasuries is an indication of that view. We still do not consider high-quality fixed income as the safe haven many investors seem to perceive.
Taking the longer view
We expect equity markets to drive economic growth, and we think emerging-market equities could outperform developed markets. In addition, we think those world markets overall will outperform U.S. equities. In our view, most markets outside the U.S. began to show more strength in the fourth quarter of 2012, while the picture has been more mixed in the year to date. Compared to the U.S., the U.K. and Japan have outperformed, and Europe and China have underperformed.
We expect to see more investment globally into emerging markets, where many economies are showing improvement. The growing middle-class population across many emerging markets and that group’s increasing consumption of goods and services have been a longstanding theme for the Fund. We’ve pursued that theme in a variety of ways over time. In the recent past, we felt many emerging-market stocks were expensive when compared with stocks of companies in developed countries that still provide exposure to emerging markets. Examples of developed-market stocks that we identify in this way include major companies such as Volkswagen, Wynn Resorts and Richemont.2
When the Fund has holdings in emerging markets, they tend to relate to what we consider country- or sector-specific opportunities.
For example, the gaming industry in Macau, China, has been a focus for the Fund because of significant demand from around the region. Sands China and Galaxy are two holdings in the Fund that represent a response to this demand.3 Going forward, we expect our approach for a more diversified range of holdings also will apply to investments related to emerging markets.
We also think many European markets will look better this year, in part because so many economies suffered from the global financial crisis and extended sovereign debt crisis. We think there are companies in Europe that can show double-digit earnings growth. That would appear strong relative to the U.S., where we expect some earnings growth but think single-digit growth rates are more likely.
- Equity risk premium (ERP) is the theory that investors should be compensated for taking additional risk. When the ERP is high, it indicates that pricing is more attractive for equity holders because each dollar of equity generates more in return. When the ERP is low, it indicates investors receive less in return for each dollar invested in equities.
- As of 12/31/2012, Volkswagen AG represented 4.7% of net assets in the Fund, Wynn Resorts, Limited represented 4.4% and Compagnie Financiere Richemont S.A. represented 1.9%
- As of 12/31/2012, Sands China Ltd. represented 5.1% of net assets in the Fund and Galaxy Entertainment Group Limited represented 3.8%.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s 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 1, 2013, and are subject to change due to market conditions or other factors.
Risk factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. The Fund may allocate from 0 to 100% of its assets between stocks, bonds and short-term instruments of issuers around the globe, as well as investments in precious metals and investments with exposure to various foreign securities. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed-income securities are subject to interest-rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. Investing in high-income securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. The Fund may focus its investments in certain regions or industries, thereby increasing its potential vulnerability to market volatility. The Fund may seek to hedge market risk on various securities, increase exposure to various markets, manage exposure to various foreign currencies, precious metals and various markets, and seek to hedge certain event risks on positions held by the Fund. Such hedging involves additional risks, as the fluctuations in the values of the derivatives may not correlate perfectly with the overall securities markets or with the underlying asset from which the derivative’s value is derived. Investing in commodities is generally considered speculative because of the significant potential for investment loss due to cyclical economic conditions, sudden political events, and adverse international monetary policies. Markets for commodities are likely to be volatile and the Fund may pay more to store and accurately value its commodity holdings than it does with the Fund’s other holdings. 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.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.