Investment Committee Perspectives

Braced for Volatility and Positioned for Opportunity in 2015

PMC Tactical ETF Core Rotation Portfolios

While many expected a rollercoaster in 2014, the year wrapped up with another bull run for U.S. equities, steady interest rates, and almost zero inflation. According to some market forecasts, expect more of the same in 2015. Do we still need to guard against risk in portfolios despite the positives of a strong dollar, lower energy prices, and potentially calm markets overall?

Positioning in 2014 and preparing for 2015

Through much of 2014, the PMC Tactical ETF Core Rotation Portfolios kept a conservative stance to preserve flexibility, while staying primed and ready to take advantage of opportunities an expected onset of heightened capital market volatility would produce.

Similar to 2013, Innealta Capital (PMC’s subadvisor to these portfolios) found insufficient support for broad exposure to many developed equity markets in 2014, while a greater number of tactical opportunities in developing equity markets were perceived during the year. This positioning was consistent with overall market performance: the MSCI EAFE Index, which tracks the equity market returns of developed countries outside of the U.S. and Canada, fell 4.2% in 2014, while the MSCI Emerging Markets Index, which fared a little better, fell by 2.1%. Throughout the year, within the Country Rotation Portfolio, tactical investments were made in eleven markets: Australia, Brazil, Hong Kong, Japan, Malaysia, Peru, Russia, Singapore, South Korea, Spain, and the United Kingdom.

In terms of the Sector Rotation Portfolio, 2014 saw tactical equity investments in the following U.S. sectors: Consumer Staples, Energy, Financials, Industrials, Information Technology, Materials, and Utilities.

Performance review through Q4 2014

Throughout 2014 and since inception, the Core Rotation Portfolios stayed true to their investment mandate, continuing to manage downside risk and achieve optimal risk-relative returns over the long-term.

Volatility (standard deviation) remained low, indicating that the portfolios have less exposure to risky investments than their benchmarks.

Consistently high Sharpe and Sortino ratios show that the portfolios have continued to provide risk-adjusted performance over the long-term and compensate investors for the risk they take on.

The Country Rotation Portfolio has also consistently provided downside protection, with drawdowns less than benchmarks in most observances since inception. The portfolio did well due to very limited exposure to countries relative to the index. Additionally, while fixed income exposure was weak, it was not as weak as the benchmarks. Both of these were strong contributors to the portfolio’s ability to protect from the downside in 2014.

While the Sector Rotation Portfolio has also historically protected well on the downside, the past two years have not been as strong. Stretched valuations and generally weak fundamental dynamics led Innealta to remain cautious on U.S. sector exposures throughout 2014. Light overall equity exposure, relative to the blended benchmark, combined with sector selection resulted in underperformance relative to the broader S&P 500. That result, in combination with the weaker-than-benchmark performance among the portfolio’s fixed income exposures, contributed to the relative underperformance during the year.

For the fixed income exposure in both the Country Rotation and Sector Rotation portfolios, Innealta was similarly cautious in terms of risk exposures, focusing on sectors with potential yield opportunities. With moderate exposure to intermediate-duration investment U.S. corporate securities throughout the year, the portfolio did not participate as fully in the capital gains resulting from the flattening of the term structure to the extent of its benchmarks. Meanwhile, emerging market debt faced increasing pressure, with the non-USD exposures particularly sensitive to the negative sentiment, while the portfolio’s U.S. short-term high yield exposures were weighted by an expansion in spreads. Considering the fixed income markets will continue to present challenges throughout 2015, the Core Rotation Portfolios remain positioned among those fixed income exposures presenting the most attractive risk-conscious yield opportunities, while providing the flexibility to take advantage of tactical opportunities expected to arise from increased volatility as capital markets come down from their central bank-induced highs.

Macroeconomics and geopolitics

The Core Rotation Portfolios were overall well-positioned for the handful of events in 2014 that many expected would make for volatile markets. For example, against the strengthening dollar, due in part to quantitative easing in Japan and Europe coinciding with a tapering of the policy in the U.S., the Country Rotation Portfolio mostly sidestepped the resulting declines in international markets by increasingly narrowing tactical equity exposures throughout 2014.

Current exposures in the Sector Rotation Portfolio may add value on a risk-adjusted basis over the first few months in 2015. For example, if short-lived, the drop in oil prices—the surprise of 2014 for many—presents opportunity for aggressive rebalancing of unfairly beaten down positions and even a few specific buying prospects. Such an example is the recent introduction of the Energy sector exposure in the Sector Rotation Portfolio.

Defensive strategy through 2015 and beyond

For the most part, markets in 2014 remained unperturbed by the uncertainty around interest rates, expectations for volatility, and the handful of geopolitical events. In fact, the year ended well for U.S. equities and fixed income (though not so much for international, emerging, and commodities). While the end of the year hinted at more volatile markets, there is still the strong possibility that capital markets remain relatively calm. However, the same risks we faced in 2014 may stretch well into 2015: tense geopolitics, challenged macroeconomic growth stories around the globe, and overvalued equity markets.

We continue to stand by the Core Rotation Portfolios for 2015. Since inception, the portfolios have proven an effective risk management strategy for the long-term—defensive relative to benchmarks and opportunistic when U.S. equity sectors and international equity markets present more attractive fundamentals versus fixed income. While Innealta Capital continues to closely watch the global equity markets for potential risk-relative opportunities, we expect the portfolios’ current exposures to add value on a risk-adjusted basis over the coming months.

The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this brochure is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment vehicle. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. Past performance is not indicative of future results.

Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) funds are subject to interest rate risk which is the risk that debt securities in a fund’s portfolio will decline in value because of increases in market interest rates.

Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Income (bond) ETFs are subject to interest rate risk which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates.

The PMC Tactical Portfolio may utilize inverse and leveraged ETFs. Leveraged ETFs are ETFs that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse ETFs utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. Inverse and leveraged ETFs are generally most suitable for sophisticated investors who understand leverage and are willing to assume the risk of magnified potential losses. Given the risk/ return trade-offs, these types of ETFs may not be appropriate for long-term investors who typically subscribe to “buy and hold” investment strategies.

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