Commentary: Second Quarter 2009 Market and Performance Update

“Less bad” news fuels a surge in investor risk appetite in second quarter

• Rallying financial markets led by stocks, corporate bonds and commodities
• Assets perceived to be riskier are favored over more conservative positioning 
• Leading economic indicators point to an end to recession, but overall data is mixed

Stocks surged in the second quarter as investors, spurred on by a slew of improving economic indicators, looked beyond any negative headlines and positioned themselves for a global economic recovery. Bond investors became more willing to take on additional risk for the sake of higher yields as the quarter progressed, and hopes grew that previously frozen credit markets were finally thawing. Sectors perceived to be riskier, such as commercial mortgage-backed securities (CMBS), high-yield bonds (those with credit quality ratings below investment grade) and emerging-market debt, posted some of the largest gains for the second quarter.

The Dow Jones Industrial Average gained 11.9% for the quarter. The S&P 500 Index ended the quarter up 15.9%, while the NASDAQ Composite Index finished up 20.3%. The MSCI AC World Index surged 22.26% in the three months through the end of June, and the Barclays Capital Global Aggregate Bond Index gained 4.93%, led by strong returns for non-government sectors. The Chicago Board Options Exchange Volatility Index (VIX), a measure of implied volatility in the S&P 500 Index that is also known as the “fear index,” dropped back to levels not seen since before the collapse of Lehman Brothers last September, and ended the quarter at 26.35. However, it remained well above long-term averages.

Stocks

In addition to signs of improvement in economic data, global equity markets were bolstered by first-quarter earnings reports that were either better than or not as bad as expected. However, in the final weeks of June, investors began to take some profits on recent big gains amid some lingering concerns that recovery may take a long time.

Still, stock markets were able to maintain their poise as more forward-looking economic indicators, such as consumer and business sentiment and earnings outlooks, continued to improve in general. Securities in the Financials sectors rebounded as large financial institutions were able to raise capital through equity offerings, boosting capital levels following the completion of the government stress tests. Energy and Materials stocks benefited from higher commodity prices. Consumer Discretionary stocks rebounded at the beginning of the quarter in anticipation of economic recovery but pulled back somewhat in June.

Bonds

Highlighting the remarkable shift in market sentiment was a gain of 23.94% for high-yield (aka “junk”) bonds in the second quarter, as measured by the Global High Yield sector of the Barclays Capital Global Aggregate Index, outpacing even the extraordinary gains in global equities. While concerns about corporate defaults by these lower-quality borrowers remained, investors were nonetheless attracted to the yields available from junk bonds as compensation against this risk.

A surge in commercial mortgage-backed securities (CMBS) over the course of the second quarter was also an example of the positive impact that U.S. government programs were having on investor sentiment. This rally was fueled in large part by the announcement in May that previously-issued CMBS would be included in the expansion of the U.S. Term Asset-Backed Securities Loan Facility program.

Emerging market debt (EMD), also perceived to be among the riskiest sectors of the fixed income markets, posted strong returns as well. However, gains for high-yield bonds, CMBS and EMD were all pared as investors turned somewhat jittery again in the final weeks of the quarter.

Toward the second half of the quarter, investors became increasingly wary of the substantial debt governments had to take on in their efforts to bail out banks and other industries (such as automakers) to stimulate their economies. In particular, longer-dated government bonds sold off amid these concerns. Yields on U.S. 10-year Treasuries rose to just shy of 4.0%, their highest levels since the demise of Lehman Brothers, on concerns that the U.S. Federal Reserve’s program of buying government bonds will not be enough to meet the increase in supply.

The Economy

More forward-looking indicators showed improving trends across major developed economies in areas such as consumer and business confidence as well as manufacturing and services activity. However, the housing market continued to deteriorate as mortgage rates rose in tandem with rising Treasury yields. Rising rates, combined with a continuing steady rise in the unemployment rate, exacerbated the accelerating pace of delinquent payments and foreclosures. However, weekly jobless claims and the number of jobs being shed showed signs of leveling off in May and June. Retail sales made gains early on only but later reversed, casting doubt on near-term recovery in the consumer sector.

Recession in Europe was worse than previously estimated in the first quarter, with an official EU estimate showing gross domestic product in the 16-nation euro zone contracted by a record 2.5%. Sharp falls were also registered in Eastern Europe. The dour sentiment was echoed in the UK, with the Bank of England labeling the economic outlook as "extraordinarily difficult.”

Still, oil prices surged on speculation that global demand will pick up, with WTI Cushing Crude ending the quarter over 40% higher, just shy of $70 per barrel. In the currency markets, mounting recovery hopes meant that the dollar continued to lose its appeal as a “safe haven” in times of global turmoil. It fell about 15% to $1.65 against sterling, while losing roughly 5% of its value against the euro to end the quarter near $1.40 and declining by 2.3% to about 96 yen.

Portfolio Review

Despite market exuberance, economic data continued to be a mixed bag of results, which is typical during this stage of the economic cycle. More forward-looking indicators showed improving trends across major developed economies over the course of the second quarter; however, the housing market continued to deteriorate. Rising rates combined with a continuing steady rise in the unemployment rate exacerbated the accelerating pace of delinquent payments and foreclosures. On the bright side, weekly jobless claims and the number of jobs being shed showed signs of leveling off in May and June.

Bond investors become more willing to take on additional risk for the sake of higher yields as the quarter progressed and hopes grew that previously frozen credit markets were finally thawing. Sectors that are perceived to be riskier posted some of the largest gains for the second quarter. Investment-grade fixed-income markets posted positive returns as investors’ risk appetites re-emerged.

On the global front, markets around the world rallied during the quarter, which was welcomed in light of first-quarter losses. Investor exuberance and incremental improvements in macroeconomic fundamentals resulted in markets having their best quarterly performance in decades. However, mixed data arriving at the end of the quarter dampened recent enthusiasm, and investors’ risk appetites abated somewhat. The World Bank announced it would lower its 2009 forecast for the global economy’s growth rate, expecting a decline of 2.9% compared to its previous estimate of a decrease of 1.7%.

Fundamental equity managers continued to outperform their quantitative counterparts, and the narrowing of value spreads helped generate positive returns for deep value and contrarian managers. Small size has been the best-performing factor year to date, and exposure to micro-cap stocks has contributed to portfolio returns. Fixed-income managers saw opportunities within the Credit sectors, and high-yield fixed-income managers benefited from the lower-quality rally. The increase in demand for higher-beta securities helped emerging-market debt as well.

What Worked in Our Portfolios:	What Didn’t Work in Our Portfolios:
Overweight to Financials in Large Cap –Security selection helped in diversified financials and insurance.	Exposure to Mean Reversion/Volatility Capture Factors in Large Cap – A sharp decline in market volatility hampered mean reversion.
Strong Security Selection in Small Cap –Selection in the Financials and Technology sectors was particularly successful.	Exposure to Earnings Momentum in Small Cap – This was the worst-performing factor in the second quarter.
Relative Valuation in International Developed Markets – Financials and consumer discretionary stocks added value.	Momentum-based Strategies for International Developed Markets – Some stocks and sectors have had large price reversals during the quarter.
Stock Selection for Emerging-Markets Equity – Consumer Discretionary, Materials and Industrials contributed to performance.	No Exposure to Sri Lanka and Serbia for Emerging-Market Debt– Both nations experienced significant rallies for their bonds.
Collateralized Loan Obligations and Other Structured Securities in High Yield – Demand returned for more complex investments.	Underweight to Gaming and Banking sectors in High Yield – Both sectors had outstanding performance for the second quarter.
Security Selection in Argentina for Emerging-Markets Debt – Argentina’s government swapped its debt and also plans to restructure other existing debt.

Manager Positioning and Opportunities

Despite a reduction in overall market volatility, high volatility continued at the individual stock level. Our fundamental managers have diversified their holdings at the margin and reduced some active sector exposures. Given the recent market dislocation followed by a sharp beta rally, our managers believe they can maintain the same or higher expected return while mitigating relative risks through stock selection within individual sectors.

In the recent rally, equity managers shifted or maintained an overweight to higher-quality companies on the margin; these firms are positioned to grow earnings as the economy slowly improves. Most of our managers believe this recovery is going to lag past recoveries and expect unemployment levels to remain high for a time, leading to a slow growth trajectory. This should reward companies adding to sales and revenue growth through brand-name recognition and competitive advantages.

Large-cap managers have positioned for an economic recovery, although economic conditions remain soft and valuations are less attractive following the rally off the March lows. Despite the increase in energy and commodity prices over the past quarter, large-cap managers have chosen to continue to invest in other opportunities that stand to benefit from gains in market share and pricing power. They also started to increase their consumer staples and utilities positions on the margin heading into the end of the quarter as these stocks lagged in the recent sharp market rally and remain attractively positioned with the economy remaining weak in the near term.

Small-cap managers have shifted or remain further out along the risk spectrum, bolstered by the continued tightening of high-yield spreads and improving fundamentals. SEI’s small-cap managers continue to like the Technology sector although they have recently trimmed their overweight positions. These managers have also shifted away from small-cap industrial names and cut exposure in the latter half of the second quarter, as economic conditions remained soft following a rally in the sector during March and April. The majority of our small-cap managers continue to avoid the Biotechnology sector, as those companies are heavily dependent on binary outcomes linked to product approval.² The recent market dislocation continues to provide better risk/reward opportunities, especially in the small- and small-to-mid-cap spaces.

Our international managers remain defensively positioned with an overweight to Healthcare and underweight to Financials and Materials. Emerging-markets equity managers are overweight to Brazil and Thailand and underweight to Russia and China; these managers are also biased toward conservative sectors such as Consumer Staples, Utilities and Telecommunications.

Fixed-income managers remain focused on securitized sectors as they believe these market segments represent the greatest fundamental value. Managers are overweight to Non-Agency Mortgage-Backed Securities and see value in Credit exposure, particularly in Financials and non-cyclical Utilities. There is also a considerable overweight to seasoned Commercial Mortgage-Backed Securities.

High-yield managers, while selectively increasing risk exposure, are staying defensive with allocations to cash and bank loans. Emerging-market-debt managers are slowly reducing allocations to high-beta credits as spreads compress. External debt has performed very well but many countries cannot afford to increase their external supply at this time and may look to the local markets for financing. Local debt issuance may become an opportunity in this space if bank lending doesn’t improve in the near term.

Outlook

In SEI’s view, while risks to global financial markets remain historically high and confidence in the health of global banks is still shaky, the worst of the recession should be behind us. SEI believes credit conditions should continue to improve over the second half of this year, as the coordinated government and central bank response really does appear to be gaining traction. If “less bad” news turns into “more good” news, investors would likely continue their move into riskier assets. However, setbacks are inevitable and will correspond to investor perceptions regarding the outlook for economic activity and corporate profitability.

SEI believes the environment for equity markets should improve in the latter half of the year as the global economy strengthens. However, the extreme levels of government and central bank stimulus will eventually need to be removed, and this could limit the growth potential of the global economy and corporate profits once they enter into a sustainable recovery. Equity markets may continue to struggle with setbacks as they remain constrained by still-declining earnings and tight conditions in the credit markets.

SEI believes non-government bond markets continue to offer better risk-adjusted opportunities for returns compared with government bonds. While defaults will certainly rise as the global recession continues, SEI believes investors continue to be amply compensated by the spreads offered in both high-yield and investment-grade corporate bonds, as well as mortgage-backed bonds and other structured securities.

¹ Higher-beta stocks are those that are more volatile than the benchmark index. They tend to offer greater potential risks and rewards than the benchmark.

² Binary outcomes are those outcomes where only one of two events will happen; for example, a coin flip will only produce a head or a tail.

Disclosures

This material is for educational purposes only and is not meant to be investment advice. The reader should consult with his/her financial advisor for more information. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results.

To determine if the Fund(s) are an appropriate investment for you, carefully consider the investment objectives, risk factors and charges and expenses before investing. This and other information can be found in the Fund's prospectus, which may be obtained by calling 1-800-DIAL-SEI. Read it carefully before investing. SEI Investments Management Corporation (SIMC) is the adviser to the SEI Funds, which are distributed by SEI Investments Distribution Co (SIDCO). SIMC and SIDCO are wholly-owned subsidiaries of SEI Investments Company.

Diversification may not protect against market risk. Current and future portfolio holdings are subject to risks as well. In addition to the normal risks associated with equity investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Narrowly focused investments and smaller companies typically exhibit higher volatility. REIT investments are subject to changes in economic conditions, credit risk and interest rate fluctuations. Bonds and bond funds will decrease in value as interest rates rise.

Index performance returns do not reflect any management fees, transaction costs or expenses. One cannot invest directly in an index. Past performance does not guarantee future results.

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