Mid cap has been the best performing size-segment this year, outperforming small caps and large caps by a wide margin. During the quarter, U.S. mid caps continued their steep ascent amid growing evidence of an economic recovery and stronger than expected corporate profits. Risk tolerances increased as investors continued to move money out of cash and low yielding money market mutual funds into higher-yielding, riskier investments in the equity, debt, and currency markets. Emerging market equities outperformed developed markets and in the U.S., value outperformed growth. The Russell Midcap Growth Index gained during the third quarter and for the year thus far.

Stocks climbed higher despite doubts surrounding the rally. Many investors had anticipated a correction given the magnitude and speed of the market recovery that began in March. However, major U.S. equity indices ended the quarter near their highest levels for the year.

Broad based gains extended across all sectors of the market during the third quarter. Technology, energy, materials, industrials, and consumer discretionary sectors were the best performing sectors in the Russell Midcap Growth Index. Defensive utilities, health care, and consumer staples segments joined financials and telecommunication services as the relative laggards.

Stocks appreciated as the economy showed broad signs of improvement. The majority of economic data released during the quarter came in above expectations. Manufacturing reports were largely positive, a slew of housing reports showed signs of stabilization, and consumer confidence improved overall. While the global recession appears to be over, the labor market is still weak. Unemployment reached 9.7% in August, a 26 year high.

Companies cut costs aggressively during the economic downturn. These efforts helped companies report second quarter profits that beat consensus earnings estimates. Analysts’ expectations were low going into the quarter and have been steadily revised higher. Following a two year streak of profit declines, analysts are now expecting a steep earnings recovery.

Mergers and acquisitions picked up after a two year decline in activity. Major deals were announced including Walt Disney’s purchase of Marvel Entertainment and Dell’s acquisition of Perot Systems. Low interest rates, improving credit markets, and high levels of corporate cash provided a favorable environment for deal making.

The Allianz RCM Mid-Cap Fund delivered a strong absolute return during the third quarter and outperformed the Russell Midcap Growth benchmark’s return. Strong stock selection among consumer discretionary, financials, and health care sectors helped the Fund outperform. Conversely, industrials and energy stock selection held back the relative outperformance.

Consumer discretionary was the biggest area of strength in the Fund. Starbucks shares climbed higher as improving sales trends and $175 million in cost savings helped the coffee retailer report a third quarter profit that topped analyst estimates. The company raised its cost cutting target for the fiscal year. Similarly, clothing maker Guess? was also top performer in the Fund.

Investments in Zions Bancorp and Lazard in the financials sector also appreciated. Zions Bancorp shares rose amid the company’s plans to raise money to improve its capital and liquidity base. Additionally, investment bank Lazard benefited from strength in its restructuring advisory business. Lazard has advised on over 100 restructuring projects this year, countering the slowdown in its mergers and acquisitions business.

Industrials holding Terex was also a standout performer. The construction equipment maker benefited from positive economic reports and the anticipation of a recovery in machinery sales. Aggressive cost controls and restructuring efforts helped Terex combat the recession, leaving it well positioned for an eventual economic recovery.

Despite the strong performance of Terex, stock selection in the industrials sector detracted from relative returns overall. Electronic instrument manufacturer Ametek shares declined after the company issued a disappointing outlook for the fiscal third quarter. Similarly, engineering and construction holding Quanta Services also declined after its third quarter forecast fell short of analyst expectations. Quanta purchased an energy services provider in North America and intends on making more acquisitions this year.

Video game maker Activision Blizzard was also a top detractor. Activision shares declined in July amid concerns about a delay in its Starcraft 2 title and weak industry sales data. The stock recovered some lost ground after reporting a better than expected second quarter.

Major equity indices retreated in early October, highlighting investors’ uncertainty about the stock market rally following the steep and swift recovery experienced since March. The Russell Midcap Growth Index has gained since reaching a 2009 low on March 9. However, we believe the market will continue to move moderately higher in the intermediate-term as the economy modestly expands over the next four quarters. Government spending, low interest rates, high levels of cash on the sidelines, and positive earnings revisions help support our positive outlook. Over 60% of the government’s $787 billion fiscal stimulus package is unspent and a surge of spending expected in 2010 should help the economy grow.

Corporate profits have exceeded analysts’ expectations for the last 2 quarters, lifted by aggressive cost cutting efforts. We believe profits will continue to top expectations as demand returns and companies benefit from the high leverage in their cost structure.