Institutional Strategies

Core Equity

A concentrated portfolio of primarily U.S. domestic companies that generally invests across the valuation and large- to mid-cap spectrum opportunistically. The goal is a portfolio of companies expected to produce long-term earnings power above expectations. As an actively managed approach, the strategy strives to outperform the S&P 500 Index over full market cycles.

Investment Philosophy

The Core Equity investment process is driven by the core belief that changes in expectations for long-term earnings power drive stock prices. Therefore, the goal is a relatively concentrated portfolio of companies expected to produce long-term earnings power above expectations and stable to improving competitive advantages. Sources of competitive advantage include, but are not limited to, superior technology, brand, scale and capital advantages. The managers believe that focusing on companies with such advantages increases the likelihood that an earnings catalyst is likely to materialize and helps to manage downside risk.

Investment Process

The selection process begins with a broad universe of all securities above $5 billion in market capitalization. They focus on companies with a 2-3 year earnings power that they believe is significantly better than market expectations. Attractive stocks are identified when they have an earnings power story that is thought to be underappreciated and have a strong competitive position which increases the probability that these forecasts can be achieved.
 
The managers focus on two distinct groups of companies that they feel are likely to produce long-term earnings in excess of expectations.

The first group of companies are the dominant participants in an underappreciated theme and are expected to produce long-term earnings power in excess of market expectations. Examples of such themes include industries at cyclical inflection points, major macro-economic/political forces, changes in consumer behavior and shifts in technology.

The second group of companies benefit from company-specific drivers which the managers believe are likely to cause the firm to exceed earnings forecasts on a multi-year basis. Company-specific drivers include, but are not limited to, new products, cost restructuring, improved management execution and positive cyclical changes in business trends.

The team utilizes analysis from daily morning meetings with the entire equity staff to assist in idea generation and identification of new opportunities. In addition, research analysts prepare formal action reports for the portfolio management team to assist in company-specific research.

Regardless of whether ideas come from company specific stories or thematic views, each company in the portfolio will have an expected long-term (2 to 3 year) earnings forecast that in the managers’ view is a significant premium to market.

The result is a relatively concentrated portfolio of approximately 40-50 securities expected to produce long-term earnings power above expectations.

Erik R. Becker, CFA

Senior Vice President, Portfolio Manager

Mr. Becker is co-portfolio manager of the firm’s Core Equity investment strategy and has served in this role since 2006. He has been affiliated with the strategy since 2003 when he assumed assistant portfolio manager responsibilities. He joined the firm as an equity investment analyst in 1999 and covered industries in the Consumer Discretionary and Industrials sectors.

Prior to joining Waddell & Reed in 1999, Mr. Becker was affiliated with Nicholas Company, Inc. as a research analyst intern.

Mr. Becker earned a MS in Finance and a BBA in Finance from the University of Wisconsin-Madison. He is a CFA charterholder.

Gus Zinn, CFA

Senior Vice President, Portfolio Manager

Mr. Zinn is co-portfolio manager of the firm’s Core Equity investment strategy and has served in this role since 2006. He began his career with Waddell & Reed in 1998 as an equity investment analyst and covered industries in the Consumer Discretionary, Industrials and Information Technology sectors. Mr. Zinn assumed assistant portfolio manager responsibilities for the firm’s Science and Technology mutual funds from 2003 to mid-2006.

Mr. Zinn earned a Masters in Finance and a BBA in Finance from the University of Wisconsin-Madison. He is a CFA charterholder.

3 years, 5 years, 10 years annualized. Returns are presented on a dollar-weighted basis and may be impacted by ongoing market volatility. Past performance is no guarantee of future results. Please inquire for more current performance information.

Total Returns1,2,3

Average Annual Total Returns as of 6/30/2017
(Returns for periods of less than 1-yr are not annualized)


QTD YTD 1YR 3YR 5YR 10YR
Core Equity - Gross 1.72% 6.73% 11.78% 5.03% 12.55% 8.00%
Core Equity - Net 1.54% 6.36% 11.00% 4.33% 11.83% 7.33%
S&P 500 Index 3.09% 9.34% 17.90% 9.61% 14.63% 7.18%

Calendar Year Returns1,2

  Core Equity Gross Core Equity Net S&P 500 Index
2016 4.51% 3.79% 11.96%
2015 0.46% -0.19% 1.38%
2014 10.61% 9.95% 13.69%
2013 35.42% 34.61% 32.39%
2012 19.61% 18.90% 16.00%
2011 1.90% 1.29% 2.11%
2010 21.63% 20.91% 15.06%
2009 23.47% 22.74% 26.46%
2008 -33.70% -34.11% -37.00%
2007 15.24% 14.56% 5.49%

1Core Equity composite is comprised of 19 accounts that had $7,498.9 million in total assets as of 6/30/17. Returns reflect the reinvestment of all dividends and other earnings. Portfolio returns are net of all foreign reclaimable and nonreclaimable withholding taxes, if applicable. Withholding taxes are recognized on an accrual basis or cash basis depending on client and/or account type. Additional information regarding treatment of withholding taxes is available upon request. Returns shown gross of fees reflect the deduction of commissions paid, but are gross of all other expenses. Net-of-fees returns are calculated by deducting the highest applicable advisory fee from the monthly gross composite return. The actual fees paid by a client may vary based on assets under management and other factors. A client’s return will be reduced by investment management fees and other expenses incurred in the management of a client’s account. Investment advisory fees are described in Part 2 of the ADV. Investment returns and the actual value of each client account will fluctuate, and at any given time an account could be worth more or less than the amount invested. • The benchmark selected for the composite is intended to provide a method to compare the composite’s performance to an index including securities that are generally similar to those that are included in the composite. However, composite holdings (and, accordingly, risk and volatility) may differ significantly from the securities tracked by its benchmark.

2The S&P 500 Index is a product of S&P Dow Jones Indices LLC (“SPDJI”), and has been licensed for use by Ivy Investment Management Company (IICO). Standard & Poor’s®, S&P® and S&P 500 Index are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by IICO. IICO's products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

3QTD return from April 1, 2017 through June 30, 2017.

Data as of 6/30/2017

10 Largest Holdings

as a % of total assets

Apple, Inc. 3.76%
Microsoft Corp. 3.53%
Alphabet, Inc. Class A 3.42%
Morgan Stanley 3.17%
JPMorgan Chase & Co. 3.00%
UnitedHealth Group, Inc. 2.91%
Philip Morris International, Inc. 2.87%
Kraft Heinz Co. (The) 2.69%
Home Depot, Inc. (The) 2.64%
Adobe Systems, Inc. 2.48%

Sector Diversification

as a % of equity assets

Information Technology 34.62%
Financials 16.15%
Health Care 12.67%
Consumer Staples 10.60%
Industrials 10.23%
Consumer Discretionary 9.10%
Energy 5.71%
Materials 0.92%

Composite Composition1

Domestic Common Stock 91.35%
Foreign Common Stock 7.33%
Cash and Cash Equivalents 1.32%

Composite Total Assets1

Assets ($M) $7,498.9
Number of Accounts 19

Supplemental data: The Core Equity holdings and sector diversification data shown are 1 of the 19 composite accounts without client specific investment restrictions and may not be reflective of the Core Equity composite as a whole or of any other Core Equity account currently, or in the future, included in such composite. The securities identified and described do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in the securities identified was or will be profitable.

1Core Equity composite is comprised of 19 accounts that had $7,498.9 million in total assets as of 6/30/17. Returns reflect the reinvestment of all dividends and other earnings. Portfolio returns are net of all foreign reclaimable and nonreclaimable withholding taxes, if applicable. Withholding taxes are recognized on an accrual basis or cash basis depending on client and/or account type. Additional information regarding treatment of withholding taxes is available upon request. Returns shown gross of fees reflect the deduction of commissions paid, but are gross of all other expenses. Net-of-fees returns are calculated by deducting the highest applicable advisory fee from the monthly gross composite return. The actual fees paid by a client may vary based on assets under management and other factors. A client’s return will be reduced by investment management fees and other expenses incurred in the management of a client’s account. Investment advisory fees are described in Part 2 of the ADV. Investment returns and the actual value of each client account will fluctuate, and at any given time an account could be worth more or less than the amount invested. • The benchmark selected for the composite is intended to provide a method to compare the composite’s performance to an index including securities that are generally similar to those that are included in the composite. However, composite holdings (and, accordingly, risk and volatility) may differ significantly from the securities tracked by its benchmark.

2The S&P 500 Index is a product of S&P Dow Jones Indices LLC (“SPDJI”), and has been licensed for use by Ivy Investment Management Company (IICO). Standard & Poor’s®, S&P® and S&P 500 Index are registered trademarks of Standard & Poor’s Financial Services LLC (“S&P”); Dow Jones® is a registered trademark of Dow Jones Trademark Holdings LLC (“Dow Jones”); and these trademarks have been licensed for use by SPDJI and sublicensed for certain purposes by IICO. IICO's products are not sponsored, endorsed, sold or promoted by SPDJI, Dow Jones, S&P, their respective affiliates, and none of such parties make any representation regarding the advisability of investing in such product(s) nor do they have any liability for any errors, omissions, or interruptions of the S&P 500 Index.

3QTD return from April 1, 2017 through June 30, 2017.

As of 6/30/2017

Portfolio Managers:
Erik R. Becker, CFA
Gus C. Zinn, CFA

Portfolio Review

For the second quarter of 2017, the S&P 500 returned 3.09%. Health Care and Information Technology were the two best performing sectors for the quarter while Energy and Telecommunications Services posted negative returns. While Information Technology performed well, the sector declined late in the quarter on profit-taking and a general move higher in interest rates that led investors to purchase more value-oriented sectors like Financials. The decline in energy-related shares continued the first quarter trend on signs that U.S. shale production would lead to large supply gains through the end of the year, prolonging the rebalancing of the oil markets. We are disappointed that our portfolio failed to keep pace with market averages, with the most significant underperformance driven by our holdings within Energy. That sector drove approximately 70% of our underperformance in the quarter.

While overall market volatility is at historically low levels, as measured by Chicago Board Options Exchange Volatility Index (the VIX), large rotations between sectors continue to pose problems for our strategy. Examples include the 2017 resurgence in biotech stocks following an 18-month down period related to pricing and election concerns, or the year-to-date stagnation in Financials following a strong rally in the second half of 2016 on Trump optimism. We are more focused on taking advantage of opportunities that may be presented by the highly rotational nature of this stock market.

The year-to-date decline in the price of West Texas Intermediate (WTI) oil from $54 to $46 has led to sharp underperformance in the Energy sector, particularly the more growth-oriented holdings that stand to benefit from increased shale drilling in North America. Moreover, our holdings within Energy have significantly underperformed the larger positions within our benchmark that tend to act as safe havens during oil price declines. As such, stock selection within Energy has been more problematic to our performance than the allocation toward the sector as a whole. We and other investors have underestimated the swiftness with which domestic producers would get back to work in the oil patch and drive supplies higher after a two-year period of reduced investment. The number of rigs drilling for oil has more than doubled to 756 at the end of June from 316 one year ago. Combined with efficiency gains (more oil generated per rig), this has led to less supply and demand rebalancing than expected. We believe that at current price levels, investment levels will again be reduced causing another modest down-cycle in drilling activity early in 2018. We have reduced weightings within the sector recognizing this pending downturn in activity. Longer-term, we believe that price levels are unsustainable in generating the investment dollars to grow production at rates that will meet global demand.

Despite the turbulence in the oil patch, the U.S. economy continues to chug along at a modest pace. Real GDP growth was 1.4% in Q1, and we expect the second quarter figure will come in somewhere around 2.7%. Further, we expect GDP in the 2.5%-3% range for the back half of the year. Job gains have averaged 180,000 per month thus far in 2017, consistent with the 182,000 per month pace of 2016. Wage growth remains modest at 2.5%, below what one might expect given the current low unemployment rate of 4.4%. As such, yields on the U.S. 10-year Treasury note have remained bound in the 2.1% to 2.6% range year-to-date. To us, it appears monetary and economic conditions are ripe for ~10% growth in S&P earnings in 2017, well above the flattish figures of the last two years.

A large source of debate today among investors is the pace of interest rate normalization by the Federal Reserve. After two rate hikes already, financial markets are assigning a 50% chance of another hike by the end of the year. We believe the chances are somewhat greater as there appears to be a large desire by Fed officials to move away from crisis-level short-term interest rates of the last several years. The Fed has also expressed a desire to reduce the size of its balance sheet by purchasing fewer long-term government bonds. This should serve to increase long-term interest rates, all else equal. At the same time, the European Central Bank also appears on the path toward moving away from extraordinarily easy monetary policy toward the end of 2017. These departures from central bank patterns of the last several years could serve to increase interest rate volatility and ultimately equity market volatility over the next 12 to 18 months. We do believe that central bank officials will be careful to tighten policy in a slow and deliberate manner to facilitate continued economic growth.

Outlook

Our current positioning reflects the general view that moderate economic growth in the U.S. will provide the underpinning for respectable gains in S&P 500 profits over the coming year. Financials, Energy, and Information Technology appear likely to lead the market’s profit recovery this year. Not surprisingly, we are overweight two of these three sectors. We expect continued gains in short-term interest rates to improve profit margins for banks and other companies in the Financials sector, but margins should remain below longer-term trend levels. Combined with regulatory relief, these changes could increase return on equity (ROE) back toward historical levels in coming years for large financial institutions, which could in turn lead to an increased willingness by investors to pay more for their earnings. Regulatory relief from the current presidential administration continues to be an important theme for the portfolio, specifically the increased ability of companies to accelerate capital return back to shareholders in the form of increased dividends and share buybacks.

Technology continues to be a large focus area for the portfolio given important secular earnings drivers. The shift in advertising budgets online, growth in semiconductor content across consumer and industrial goods, growth in electronic payments, and the movement of software models to cloud-based platforms all provide high levels of growth visibility for many years. While the market has increasingly recognized superior growth rates in some companies’ valuation multiples, we still find several attractive technology stocks where future earnings expectations continue to be underestimated. Recent additions to our technology investments are three holdings, each benefitting from one or more of the trends listed above.

As discussed above, we have tempered our views on the Energy sector since the beginning of 2017 and currently stand slightly underweight versus both the S&P 500 Index and the Russell 1000 Index. Rapid growth in U.S. drilling activity alongside the return of capacity among some lesser OPEC members (Libya and Nigeria) have combined to undermine the recovery in oil price levels. Though we think the ultimate direction of oil will be up from here over a 2-3 year time horizon, our more immediate view of a positive upcycle failed to materialize. We continue to focus on the few companies that have dominant positions in the lowest cost oil basins in the U.S. With our changing oil views, we have also reduced other Energy-related holdings such as our railroad investments.

We continue to have a pro-cyclical tilt to our portfolio, meaning we would expect that our portfolio will perform better when investors are optimistic regarding modest global growth and a slow rate of interest rate normalization. We acknowledge that our positioning since the second half of 2014 in slightly higher risk (as measured by portfolio beta >1) and pro-cyclical groups (underweight bond-proxy groups such as Utilities, Telecommunications, and REITS) has had a negative effect on relative performance. That said, we see signs that for the first time in many years that investors are beginning to punish low-growth or no-growth companies that trade at high valuation multiples. We are still optimistic that our approach will lead to improved performance in coming quarters and years.

The opinions expressed in this commentary are those of the portfolio managers and are current through June 30, 2017. The managers' views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.  Any mention of investment performance refers to gross-of-fees performance, unless otherwise noted. 
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Key Features

Composite Performance History Since 1/1/1995
Benchmark S&P 500 Index
Style Fundamental, Core: Growth and Value
Target Alpha 200 bps above Index
Over full market cycles (3-5 years)
Peer Universe U.S. Large Cap Core Equity
Typical Tracking Error 300-500 bps
Holdings Range 40-50
Max Position Size Greater of 6% or 2.5X Index
Sectors Generally range from 1/2 to 2X the Index weights and are highly dependent on emphasized themes
Investment Vehicles Institutional Separate Account
Collective Investment Trust
U.S. Mutual Fund: Institutional Share Class
Variable Insurance Portfolio