Global flexibility backed by in-depth research: Assessing volatility, policy risk and security selection around the world
Michael L. Avery
Ryan F. Caldwell
Waddell & Reed Advisors Asset Strategy Fund - August 2012
True flexibility and global reac h – a phrase that has described the Waddell & Reed Asset Strategy Fund throughout its history. That mandate has the potential to offer particular value to investors now in a world of low interest rates and uncertain economic policies. Through the Waddell & Reed collaborative process, we pursue opportunities worldwide that support our goal of total return within a framework of capital preservation and risk management.
A viewpoint on volatility in the Fund
Many investors in today’s markets have begun to equate low volatility with low risk, and are willing to accept the returns that result. We do not think volatility is the same as risk, as we have said before, and we do not target a volatility level in the Fund. In short, we don’t think the pursuit of low volatility is a sustainable long-term strategy for investors.
The search for low volatility often ends at long-duration government securities, investment-grade credit instruments and stocks paying high dividend yields. While the volatility of such securities in general may be lower now than domestic or global equities, they often show what we call episodic volatility – both very high and very low.
In looking at low volatility with what might be seen as acceptable returns, the focus has become the U.S. Treasury market. But as we have said before, we think that approach will not provide a long-term solution for investors. We have anchored the Fund in equities, where we think valuations still are attractive. We also think we can price risk more effectively there. We believe we can generate returns with this strategy to help investors outpace future inflation.
In our view, the current historically low interest rates – which we think are likely to stay low into at least 2014 – still mean fixedincome securities carry risks that may become even more apparent when rates eventually begin to rise. And we think we’re in a period in which monetary and fiscal policy responses will provoke investor behavior in a way that will be favorable for global equity markets.
We’re also seeing investors pursuing lower volatility through investment-grade credit securities. But that strategy requires investors to take more duration risk when seeking returns. This is another example of what we consider episodic volatility, which we think could increase in the future.
Finally, we have begun to see investors pursue high dividend yields from stocks as a proxy for bonds. In our view, this approach still raises the potential for episodic volatility through the varying cash flows over time at dividend-paying companies. These companies, like most others, are subject to competitive forces that can erode cash flow.
Given the amount of capital that has flooded into dividend-paying stocks, we think many dividend payers are richly valued now. We think they may not hold their valuations as well as growth-oriented stocks in the long term. We therefore think investors may find it difficult to reach a goal that includes low volatility with acceptable returns using such an approach.
In looking at past investor behavior and comparing it with the current markets, we think many may be simply following a trend. As often happens, investors chase the asset class that had performance in the past. Now, we think many are adding the pursuit of low volatility. We do not believe such a strategy will provide the impetus to drive returns going forward.
When we have decided to be defensive in the Fund, we historically have increased the cash position as a method to protect assets. In the current markets, putting assets in cash means an automatic decline in real purchasing power because of the level of interest rates vs. inflation. For example, three-month Treasury bills were yielding only 0.09 percent in June while U.S. inflation was running at an annual rate of 1.4 percent in July.1 The Fund can use cash as an asset class, but it’s tough for us to accept a built-in loss through a defensive asset class. We therefore are not using cash to a significant degree now. That could change, of course, if the environment changes. We could return to cash in the future if we wanted a defensive position and determined rates could provide positive return to investors.
The Fund continues to hold gold bullion as a hard asset and a currency hedge, as well as a hedge against the uncertainties of government monetary and fiscal policies around the globe. We believe there is a place for gold bullion in the Fund and expect that to continue as we watch for policy makers to provide clearer direction for the global economic future.
Flexibility and process: Formula One
The Fund’s pioneering investment approach provides the ability to move among all global asset classes with virtually no constraints. A recent investment in Formula One2 (F1) clearly illustrates that flexibility. F1 is widely considered the world’s top motor racing series. Our investment in private equity and debt marked one of the most significant changes to the portfolio in the past two years. It became the largest overall holding at the end of the second quarter.
The Fund’s portfolio management team worked with analysts across our equities and fixed income teams to complete a lengthy, in-depth due diligence process. We think F1 is a unique business, which includes predictable cash flows from its long-term TV contracts and event promotion contracts. In that regard, we think it is similar to the Fund’s investment in CBS Corp.3 in 2010. That selection also was based in part on the increasing potential revenue from the broadcast rights for live sports, such as professional football and golf, and college football and basketball. We feel F1 could represent a similar opportunity.
F1 owns and sells the rights to host motor racing events around the world, along with their media rights. The schedule for 2012 has 20 races worldwide, with most in Europe and Asia. F1 also sells advertising and sponsorships, and licenses merchandise for the series and its related racing circuits.
This top-level motor racing series is one of the most popular sports worldwide. F1 estimates it drew more than one-half billion TV viewers worldwide in 2010. It tends to attract a wealthy, more global fan base. TV viewership is well established in Europe and is growing in Asia and the Middle East. And an F1 race scheduled for November near Austin, TX, may spur increased interest and viewership in the U.S.
F1 recently renegotiated TV contracts in key markets, including the U.K. and Italy, at significant increases from previous deals. As broadcasters look for content that consumers want to watch in real time, the value of live sports rights and the resulting price to broadcasters have increased.
We think F1 illustrates the Fund’s strategy in several ways. It’s an example of investment flexibility that draws on the expanding emerging-market consumer base and is based in solid cash flows from the live sports rights contracts.
China’s consumers remain in focus
China is the world’s second-largest economy by nominal gross domestic product (GDP) and the world’s fastest-growing major economy. It has grown its economy by an average of 10 percent per year over the past 30 years, as measured by its GDP. It also is a key driver of the global economy as the world’s largest exporter and second-largest importer.4
While that growth rate has slowed this year, we estimate China’s GDP can more than double from its current annual rate of 6 to 7 percent over the next 10 years. That’s the fundamental reason we remain bullish on China and other Asian markets.
We think it’s important to differentiate between what’s happening in the Chinese economy and how we invest in that economy. We see it as an example of the benefit of active management versus passive management in emerging markets.
China’s government has taken steps to slow economic growth from its previous levels. The central bank has eased interest rates and lowered bank reserve requirements, demonstrating that China wants to maintain steady – but not overly fast – growth. Individual stock selections related to China have become even more important. We think the situation argues against investing in China via the Hong Kong stock market index or other passive methods.
Instead, our active management style continues to lead us to a selective list of opportunities, using investments in companies located in the emerging markets as well as those in the developed world with solid positions in those markets.
Even with the slower growth in China’s economy overall, mass market consumption is growing across a wide range of products. And we see much more room to grow. China’s ratio of consumer consumption to GDP is about 38 percent, according to The World Bank, which is among the lowest of major global economies. By comparison, the ratio in the U.S. is 70 percent.
That difference is just one example of why we continue to focus on consumers. We’re working to capture their increased consumption in the Fund, both from China and across emerging markets generally. For example, the Fund holds positions in companies representing global automakers, global gaming, luxury goods, technology and financials – all with strong market positions in the region. These industries are leading the way in increased consumer consumption in the region.
Policy makers must lead the way
We think policy makers around the world must take action now to deal with the fiscal and monetary challenges that are restraining global economic growth. Uncertainty about policy responses to the ongoing sovereign debt crisis in the eurozone and the U.S. “fiscal cliff” of expiring tax cuts and social benefits are just two examples. Both have had significant effects on global markets.
In our view, the world still is in a balance sheet recession. Human behavior suggests that policy makers and central bankers are likely to respond with more aggressive monetary policy and more fiscal stimulus to push economic growth. We think these actions may tend to push equities prices higher in the short to medium term. But we do not think such stimulus will provide the long-term solution for rising debt levels around the globe.
Waddell & Reed Advisors Asset Strategy Fund
Global. Flexible. Authentic.
For more than 15 years, Waddell & Reed Asset Strategy Fund has applied a consistent investment management approach that provides the ability to move among all global asset classes, without constraints, in order to offer investors what the Fund feels is an appropriate risk/return profile.
The Fund seeks attractive returns within a framework that values capital preservation and risk management.
It is a pioneer in this investment approach and has not wavered from its original theme of tactical, global asset allocation.
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 August 15, 2012, and are subject to change due to market conditions or other factors.
Consider all 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 percent 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.