Waddell & Reed

Portfolio Perspectives

Market evolution leads to broader mix in equities allocation

Story Highlights

  • The Fund now has a more diversified, global portfolio than it held in late 2012.
  • We continue to prefer equities in general over fixed income.
  • We think emerging markets will continue to underperform developed markets as long as growth is slow.
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Investment Team

Manager Name

Michael Avery

Co-Portfolio Manager

Manager Name

Ryan Caldwell

Co-Portfolio Manager

The Waddell & Reed Advisors Asset Strategy Fund this year has revised its underlying mix of equities from the previous highly concentrated portfolio to a broader mix of equities. We think this change reflects the Fund’s flexibility as well as our attention to risk management in the portfolio.

As we said in a commentary earlier this year, we think this adjustment will reduce stock-specific risk and instead put a focus on the systemic risk of equity markets and exposure to certain security characteristics.

The Fund now has a more diversified, global portfolio of about 100 individual equity holdings as well as some broad index exposure, which is about double the number of holdings in late 2012. We continue to prefer equities in general over fixed income because we think equity valuations remain more attractive and we can more effectively price risk in equities.

We believe the increase in the number of equity holdings, smaller weightings in many cases and greater liquidity through a somewhat larger allocation to cash also position the Fund to adjust more effectively and become defensive if needed in the future. It’s important to note that we do not think such a change is likely in the near term and the Fund continues to lean toward equities. But we believe the current portfolio is less aggressive than it was a year ago. In assessing the market’s direction, we continue to watch key indicators, such as free cash flow yields, price- earnings ratios and gross profit yields.

The change in equities holdings also has affected sector allocations. As we’ve noted in the past, our focus typically is on individual security selection. Sectors largely are the result of those decisions. But recently we have materially reduced holdings in several sectors, including autos and luxury goods. We still have significant holdings in the gaming sector, particularly related to Macau, where tourism and gaming continue to grow.

Focused approach to China, emerging markets

The Fund’s investments in Macau reflect our overall strategy to be very specific in our exposure to China. We continue to think the best approach is to invest in a targeted way in equities related to areas where we believe consumption will increase. The focus on Macau and its gaming industry provide a clear example, as does our holding in a large Hong Kong-based insurance company serving primarily Southeast Asia.

We think China’s leaders are comfortable letting slower growth work its way into the economy as it continues to evolve. We think China’s economy is growing at an annual rate of 7% to 8% overall, with variations across the country. In our view, this indicates a focus on increasing consumption and improving standards of living — not driving toward double-digit growth in gross domestic product.

Given the continued slow growth around the world, we now think emerging-market equities may have a difficult time compared with developed markets, especially the U.S., Japan and Europe. Strength has returned to U.S. equities and those markets are improving in Japan and Europe, too. Going forward, we think emerging markets will continue to underperform developed markets as long as growth is slow. However, we think the significant performance gap between the markets in the U.S. and Japan — compared with other major equity indexes — is likely to narrow as the year goes on. The Fund’s holdings reflect this view.

Low interest rates, low inflation

Despite gains in the U.S. stock market and increases in housing prices, we do not think there is a risk of significant, widespread inflation in the near term. That is in part because corporate capital spending and consumer spending remain modest. In addition, there appears to be limited upward pressure on wages in the developed world, which is a significant restraint on inflation. We think this may explain why U.S. inflation remains low — averaging about 2%.

In our view, renewed corporate spending on a large scale could be a catalyst for growth. But many corporations continue to hold substantial amounts of cash on their balance sheets. They often are using it to pay dividends or complete stock buybacks, which tend to support their stock prices. We think an increase in corporate capital expenditures globally in the future could mark a changing point for both fixed-income and equities markets. But rising stock prices in general and slow economic growth overall have not yet pushed companies in that direction.

Early in the financial crisis, a “flight to safety” into fixed income and out of equities made it easy for corporations and governments to borrow money at historically low interest rates. But investors have begun to seek more return for their loan risk. Many who parked assets in short-term securities that they perceived as safe now want more yield as a source of income. This has prompted a move for many investors toward assets such as high-yield debt and dividend-paying equities. Recent concerns about the Federal Reserve “tapering” some of its aggressiveness appears to have moderated investor enthusiasm for chasing yield.

We also think there still is a great deal of “cash on the sidelines,” with investors still holding back on reinvestment in equities. Equity flows have tended to focus on stocks with high dividend yields — which are among the most expensive now — or into index-type investments. We therefore think the current situation is an indication that many investors still are hesitant about taking on the additional risk of equities while trailing returns on fixed income are still attractive. We will be watching investor behavior, as the total return of major fixed-income indexes has turned slightly negative in the year to date.

Coming into the year, we thought gold could underperform equities, although not to the magnitude we have seen. In the current environment of rising equities prices and declining market volatility, gold largely has not been a preferred asset class. No central banks have been aggressively buying it, as has been the case in the U.S. Treasury market. Treasuries thus have held up much better in relative terms than gold, although both still are considered “safer” assets for higher volatility times. But we think we’re entering a period in which volatility will be low for a while.

We still invest in gold as a hedge against the continued intervention by government policy makers into capital markets and economies worldwide. As we consistently have stated we consider gold to be a hedge for the currency exposure we face in the rest of the portfolio.

Continued focus on equities

In our view, there are a range of potential challenges for the markets in the future, including the continued credit cycle and slow economic growth, the leadership transition in China, upcoming elections in Germany that have wider implications for Europe and its austerity programs and the ongoing unrest across the Middle East. We also are watching progress in Japan following recent aggressive actions from policy makers there. We think these issues may add to investor uncertainty.

We continue to think that the bottom of the capital structure — including investments such as high-yield debt securities and equities — offers more return potential for less risk than other potential investment choices. We believe it will continue to do so in the short to medium term. We also think continued aggressive monetary policy actions are likely to benefit equities over that period.

Given our view, we will keep the Fund positioned to seek to take advantage of potential opportunities, especially in equities that fit our preference for strong free cash flow and exposure to growing markets. If we determine that market conditions warrant otherwise in the future, the Fund’s mandate provides the flexibility for us to quickly allocate assets as we believe appropriate.

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 June 7, 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.

Diversification does not guarantee a profit or protect against loss in a declining market. It is a method to manage risk.

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.

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