- For most of 2016, the market favored equity strategies focused on high-dividend yields.
- Big changes occurred post election, when investors re-embraced risk and adopted a more pro-growth, pro-cyclical investment stance.
- The Fund's actively managed approach to income and growth investing can help tap sources of return usually unavailable to narrowly focused dividend strategies.
For most of 2016, the market favored equity strategies focused on high-dividend yields. However, the market changed direction after the U.S. election, when investors re-embraced risk and adopted a more pro-growth, pro-cyclical investment stance.
Interest rates also increased significantly during fourth quarter 2016 as the fixed-income market digested the potential for better growth, increased inflation and a less accommodative Federal Reserve. In this environment, the Ivy Mid Cap Income Opportunities Fund outperformed the Russell Midcap Index (its benchmark) for the one-year and since inception periods ended Dec. 31, 2016. Below, Portfolio Managers Nathan Brown, CFA and Kimberly Scott, CFA discuss the Fund’s investment philosophy, 2016 performance and investment opportunities they are seeing in today’s market.
The differentiator among dividend funds: capital appreciation through earnings growth
Since its inception on October 1, 2014, the Ivy Mid Cap Income Opportunities Fund has outperformed its benchmark by more than 800 basis points. While the Fund has provided competitive results over the past two years, the majority of the excess return was generated in calendar year 2016. The market environment for much of 2016 included a period of strong relative performance by equity strategies that focused on high-dividend yields. Contrary to many of these more automated and single focus income-oriented funds, the Fund has continued to perform better than its benchmark in the wake of the market change that came post-election, when investors re-embraced risk and adopted a more pro-growth, pro-cyclical investment stance.
Our actively managed approach to investing for both income and growth has allowed the Fund to tap sources of return that are usually unavailable to more narrowly focused dividend strategies, where the emphasis is typically on utilities, real estate investment trusts (REITs) and consumer staples. It is this differentiated approach that has allowed the Fund to continue to perform well as the market’s emphasis on income and low volatility factors has faded.
The genesis of the Ivy Mid Cap Income Opportunities Fund’s strategy is based on our long-standing experience of investing in mid-cap growth businesses. We seek what we believe to be attractive return opportunities in a specific sub-set of this universe — stocks of many companies that still have a long-term opportunity to grow earnings and cash flow at attractive rates relative to the overall market, but are now also able to return capital to shareholders, generally in the form of a dividend. The crucial differentiator of the Fund versus many other dividend-income strategies is that the Fund is a total return strategy with an income component that provides a clear pathway to capital appreciation through earnings growth. The Fund enables investors to receive an attractive and competitive yield, and also have the opportunity for capital appreciation over time, as these companies are still growing earnings and cash flow, which should translate into higher stock prices with time, given valuation support. The growth in earnings and cash flow of the companies owned by the Fund supports dividend growth as well as offers investors in the strategy the possibility of getting a “raise” each year as dividends increase. The bottom line … the Fund has a growth-oriented strategy within the universe of midcap dividend payers that has the potential to generate attractive returns in several market environments that narrowly focused income strategies cannot.
More to fund performance than riding the tailwinds of dividend yield
The performance numbers are interesting. See chart below. Since the Fund’s inception, its cumulative return over the period was 27.60% versus 19.28% for the benchmark. The highest and more moderately higher dividend yielding stocks, as determined by rank in the first two quintiles of the Russell Midcap Index universe, generated more than 56% of the return in the index during this same time period. In calendar year 2016, the Fund outperformed the index by 860 basis points and during the same one-year time period, the first two quintiles of dividend yield generated 61% of the index’s return. After the U.S. election, the market changed. Prior to the election, 78% of the index’s return came from the top two quintiles of dividend yield and after the election only 42% of the index’s return came from the top two quintiles.
Most of the stocks in the Ivy Mid Cap Income Opportunities Fund fall in the two highest quintiles of dividend yield, thereby, delivering essentially 100% of return in the strategy over all the periods noted. While dividend yield as a return factor has trailed the index since the election, the Fund, with most of its names residing in the top two quintiles of dividend yield, has continued to outperform the index, delivering 148 basis points of outperformance since market close on Nov. 8, 2016.
In addition, those two highest quintiles, by definition have driven essentially 100% of the Fund’s returns over all of the comparable periods. This indicates that some factor other than dividend yield has been at play in the strategy’s ongoing outperformance. We believe that the factor is growth — an active approach to seeking well-valued stocks of companies that can deliver earnings and cash flow into the future, support and grow a dividend, and offer a higher stock price over time.
Risk Factor/Dividend Yield (%)
Source: Morningstar Direct and Barra Analytics. Past performance is no guarantee of future results. See standardized performance at the bottom of the page. Performance at net asset value (NAV) does not include the effect of sales charges, if it had, performance would have been lower.
1 Pre-election time period: 01/01/2016 - 11/08/2016
2Post-election time period: 11/09/2016-12/31/2016
3Since Fund’s inception (cumulative return): 10/02/2014-12/31/2016 (Note: While the Fund’s inception date is 10/01/2014, the first trading day was 10/02/2014.)
Fund performance in bull markets
Make no mistake, the Ivy Mid Cap Income Opportunities Fund seeks to own growing businesses. The vision for this strategy, relative to more aggressive growth funds, emphasizes lower volatility, lower turnover and strong risk-adjusted returns for investors who want both income and exposure to the dynamic and growing U.S. economy through equities.
The expectation has been, and continues to be, that the Fund will participate in, but likely underperform versus the index in strong risk-oriented bull markets. It has the potential to perform better against its index in trending up markets and difficult down markets. Lower turnover in the concentrated portfolio of 35 to 50 names is a residual of seeking to invest in companies that are generally core and stable growers in the mid-cap universe. The business models of these companies tend to be fundamentally less volatile, with greater earnings, cash flow, and capital return predictability and durability. Many valuation metrics can be used to determine buy and sell price targets, but dividend yield is the key metric given its importance in contributing to total return, and its relevance as a very tangible arbiter of valuation excess or attractiveness. The primary objective for turnover in the Fund’s portfolio is valuation targets reached, but changes in investment thesis or uncertainty around the integrity of the dividend can also trigger holdings changes.
Examples of turnover in recent quarters include selling American Water Works Company after significant price appreciation drove its price-to-earnings multiple to historic highs and the dividend yield to what we considered unsustainably low levels — both a recipe for near- to intermediate-term underperformance. OGE Energy Corporation, an electric utility and natural gas midstream operator, was purchased in American Water Works Company’s place. OGE had a compelling valuation, with its dividend yield near 4%, and a differentiated growth opportunity as a utility given its electric utility operations in the south central U.S. and its exposure to the energy infrastructure through its natural gas midstream business.
An acute investment thesis change led to the sale of Corrections Corporation, now renamed CoreCivic, Inc. and the purchase of American Campus Communities, Inc. The stock of CoreCivic came under considerable pressure and the outlook for the company became murky as the Obama administration moved to reduce the use of private prisons to house inmates. The outcome of this directive is now unclear, with the potential for less pressure on CoreCivic’s business given the coming change in administrations. This uncertainty dictated a more prudent investment of those assets, thus the purchase of American Campus Communities, a REIT that owns, manages and develops student housing in the U.S., a dynamic and growing segment of the real estate sector.
The Fund’s 2016 performance has been a testament to two key factors. First factor: “Being in the right place at the right time” as the Fund benefited from the demand for income in the equity market. Second factor: Strong active management that took advantage of a second level driver within that key trend (attractive earnings and cash flow growth over the 12-month period). Earnings and cash flow growth will always be the key components of the Fund’s underlying core investment philosophy and strategy, differentiating it from other passively-oriented plain vanilla dividend-income strategies. This is the basis upon which we believe the Ivy Mid Income Opportunities Fund has the potential to deliver solid performance as investor preference for narrowly-focused income and low volatility strategies fade.
Fund Performance – Average Annual Total Returns (%)
Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be worth more or less than their original cost. Please visit ivyinvestments.com for the Fund’s most recent month-end performance. Class A Share performance, including sales charges, reflects the maximum applicable front-end sales load of 5.75%. Performance at net asset value (NAV) does not include the effect of sales charges. The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It is not possible to invest directly in an index.
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 January 2017, and are subject to change due to market conditions or other factors.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. The Fund’s emphasis on dividend paying stocks involves the risk that such stocks may fall out of favor with investors and underperform non-dividend paying stocks and the market as a whole over any period of time. In addition, there is no guarantee that the companies in which the Fund invests will declare dividends in the future or that dividends, if declared, will remain at current levels or increase over time. The amount of any dividend the company may pay may fluctuate significantly. In addition, the value of dividend-paying common stocks can decline when interest rates rise as fixed-income investments become more attractive to investors. This risk may be greater due to the current period of historically low interest rates. The Fund typically holds a limited number of stocks (generally 35 to 50). As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a large number of securities. 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.
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Through July 31, 2017, Ivy Investment Management Company (IICO), the Fund’s investment manager, Ivy Distributors, Inc. (IDI), the Fund’s distributor, and/or Waddell & Reed Services Company, doing business as WI Services Company (WISC), the Fund’s transfer agent, have contractually agreed to reimburse sufficient management fees, 12b-1 fees and/or shareholder servicing fees to cap the total annual ordinary fund operating expenses for the Fund’s Class A shares at 1.35%. Prior to that date, the expense limitation may not be terminated by IICO, IDI, WISC or the Board of Trustees (Board).