Past performance is no guarantee of future results. Investment return and principal value will fluctuate so that shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than that shown here.
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The views expressed in this investment report represent the opinions of PNC Capital Advisors, LLC and are not intended to predict or depict performance of any investment. All information contained herein is for informational purposes and should not be construed as investment advice. It does not constitute an offer, solicitation or recommendation to purchase any security. The information herein was obtained by various sources; we do not guarantee its accuracy or completeness. Fund performance quoted above is for class I shares. Past performance does not guarantee future results. These views are as of the date of this publication and are subject to change based on subsequent developments.
Investments in small capitalization companies present greater risk of loss than investments in large companies. Investments in value companies can continue to be undervalued for long periods of time and be more volatile than the stock market in general. International investments are subject to special risks not ordinarily associated with domestic investments, including currency fluctuations, economic and political change and differing accounting standards that may adversely affect portfolio securities. These risks may be heightened in emerging markets. To the extent that the Fund invests a significant portion of its assets in a particular industry, the fund's performance could depend heavily on the performance of that industry and may be more volatile than less concentrated funds. The portfolio team may choose to invest in initial public offerings (IPOs), the performance of which is unpredictable and the effect of which may not be duplicated during periods in which the Fund does not invest in IPOs.
PNC Multi-Factor Small Cap Value Fund (class I) returned 11.33% in the first quarter versus a return of
11.93% for the benchmark Russell 2000 Value Index.
Sector allocation had a lesser impact on performance than stock selection, a normal characteristic of our process. Overall, from a sector perspective, the largest detractors from relative performance were Information Technology and Real Estate. The Fund’s underperformance was driven by two software industry holdings—one in the portfolio that underperformed, and one not owned in the portfolio that outperformed. Our lack of exposure to the semiconductor industry also held the portfolio back. The real estate investment trust industry generated all of the underperformance in the Real Estate sector. Contributions from the Industrials, Consumer Discretionary, and Financials sectors helped to mitigate underperformance.
Rebounding from a 20% decline in the final quarter of 2018, the Russell 2000 Index gained 14.60% in first quarter 2019. As the quarter began, small caps were driven by more growth-oriented sectors, such as Information Technology and Health Care, as well as Energy. However, toward the end of the quarter, more defensive sectors, such as Utilities, were among the top performers.
A renewed risk-on environment drove stocks with low return on equity (ROE), high debt, and high beta to outperform, as measured by the Russell 2000 Index. Overall, quality stocks within the Russell 2000 have become scarcer, with their proportion of the index growing steadily since about 2012. Now, more than 25% of the stocks within the Russell 2000 are non-earners (i.e., companies that have negative ROE/no earnings).
Unlike the Russell 2000 and Russell 2000 Growth indexes, higher-quality stocks within the Russell 2000 Value Index topped lower-quality stocks for a while during the first quarter. In February, top-quintile earners (i.e., high quarterly ROE) in the Russell 2000 Value Index outperformed the bottom quintile (i.e., low quarterly ROE) by nearly one percent, in stark contrast to the core and growth indexes.
Our process is rooted in a variety of investment characteristics that have demonstrated long-term outperformance, including reasonable valuations, improving fundamentals, and momentum. Our process has led us to more stable, higher-quality stocks, which were out of favor this quarter. When volatile and/or low-quality stocks outperformed their more stable or trending high-quality peers, our Funds have tended to underperform. Additionally, when market trends fluctuate sharply from month to month, as we have witnessed over the past several quarters, our models have tended to encounter a difficult time generating alpha.
The first quarter of 2019 was marked by a reversal in trends. The factors that were effective in the fourth quarter of 2018, such as free cash flow, ROE, and return on invested capital, were ineffective throughout the first quarter. Instead, the small-cap stocks with the highest returns tended to be higher risk and lower quality.
After the Russell 2000 Index dropped more than 20% in the fourth quarter of 2018, many investors sought to reap the benefits of lower valuations and oversold stocks. Across the entire quarter, stocks with higher beta generally outperformed stocks with lower beta.
As investors targeted oversold stocks, countless seemed to buy securities with higher debt-to-asset ratios, especially in Financials, while focusing on growth in sectors such as Industrials, Information Technology, and Materials. Typically, small-cap companies that add assets too quickly have difficulty managing growth, which then may reduce the probability of higher future earnings. This did not seem to be a concern for investors this quarter.
For the last several quarters, valuations have not been an effective driver/predictor of future returns. Investors seemed to capitalize on the market’s downturn, pushing factors like book-to-price and earnings-to-price to the top of the pack. After showing strength in January, valuations ultimately did not matter in the market, and therefore are again the worst factor group this quarter.