Small Cap Fund

(As of 9/30/21) — Equity market returns were somewhat mixed in the 3rd quarter, but the S&P 500 Index etched out a modestly positive return of 0.58%. The global recovery hit a speed bump during the period as the world dealt with rising COVID-19 Delta variant infections, an energy price spike, and supply chain issues that continued to constrain economic growth. After trading lower earlier in the quarter, interest rates increased later in the period in response to higher-than-expected inflation data and an admission from the Federal Reserve (the “Fed”) that they would need to begin removing monetary stimulus from the economy sometime soon.

The Russell 3000 Index declined -0.10% in the quarter. Growth stocks outperformed Value stocks as the Russell 3000 Growth Index returned 0.69% versus a drop of -0.93% for the Russell 3000 Value Index. Relative performance was correlated with market cap size as large caps outperformed small caps in the quarter. The large cap Russell 1000 Index returned 0.21% compared to the Russell Midcap Index return of -0.93%. Smaller market cap indices were even more negative, with the Russell 2000 Index returning -4.36% and the Russell Microcap Index returning -4.98%. Financials were the top performing sector for the quarter, while Industrials and Materials were lagging sectors.

(As of 9/30/21) — The outlook for small caps remains somewhat mixed, in our view. Investor concerns over rising inflation, a planned reduction in the Fed’s purchase of bonds, higher interest rates, a looming debt ceiling vote, uncertainty in Washington, continued economic headwinds from supply chain disruptions, and ongoing fears of additional COVID outbreaks weighs on market sentiment and drives investors to the relative safety of larger cap companies or less risky assets. As one can surmise from the length of the list of concerns, there is definitely a decently sized “wall of worry” impacting investors. We believe many of these concerns are already “baked into the cake,” noting that small cap growth stocks have experienced a significant amount of relative underperformance this year. Furthermore, small cap stocks tend to outperform as the economy accelerates and with the worst of the Delta variant seemingly behind us, most economists have 4th quarter GDP picking back up, after ratcheting down 3rd quarter growth expectations due to COVID. We also note that small caps tend to outperform in periods of rising interest rates, as this is generally a sign of an improving economy. The yield on 10-year US Treasury Bonds has started rising after bottoming in July 2021.

While growth stocks may continue to lag value if the economy experiences an acceleration due to supply chain improvements or as COVID fears wane, we remain confident in the outlook for growth stocks in the medium- to long-term, as high government debt levels may eventually weigh on outsized GDP growth, giving growth companies premium positioning with investors. We are cognizant of the negative impact rising interest rates typically have on long duration assets, characterized by high valuations and significant operating losses, and are positioning the portfolio accordingly.

This quarter was noteworthy for the Fund in that, staying true to a small cap focus and investing in smaller market cap companies, did not work as well as hanging on to “winners” which have now become mid-cap companies. In our post-mortem of the quarter’s performance, we noticed that the Fund’s smaller market cap holdings (those under $1.8 billion in market cap) meaningfully underperformed investments above that cap range. Relative to the benchmark index, the portfolio maintained an overweight to smaller companies (under $1.8 billion or less in market cap), which contributed to our performance shortfall. We observe that our Fund typically underperforms during significant rotations out of the smaller market cap range and during significant rotation towards value from growth. This quarter was true to form. We take some comfort in that prior periods such as late 2018/early 2019 and late 2016/early 2017, this phenomenon has been short lived. In closing, we remain highly confident in our time-tested investment process, the companies in the portfolio, and the new ideas we continue to uncover. As always, we appreciate your continued support over the long run.