As the build-up to the US election gathers momentum, the markets are feeling the heat of the investing spotlight. Despite threats of a slowdown in economic growth, a devastating hurricane and some analysts warning that the nation may be teetering on the edge of a financial precipice, most remain neutral about it as an investment region.
If you're eyeing up the US, accessing it via exchange traded funds (ETFs) can prove a real advantage over other forms of investment. This is because you can achieve much greater diversification while only paying once for transaction costs - making it much cheaper than buying single stocks. Plus, traditionally, many actively managed funds have struggled to beat their benchmark indices because the US market is so efficient, meaning more investors should consider passive strategies for the US market, such as ETFs.
It sounds simple, but there's a huge disparity in the US ETFs out there. To make it easier, there are several factors you need to consider before you invest.
US ETFs track different indices containing selections of US-listed companies ranked in different ways. The most popular is the S&P 500 index, which tracks the largest US companies according to their share price. The iShares S&P 500 ETF (IUSA) is a large fund that comes highly recommended. Its one of the costlier S&P tracking ETFs with a total expense ratio (TER) of 0.4 per cent. This is because it used to have exclusivity on the index, but having lost this status almost two years ago (and not reduced its price), other funds have come in and undercut it - such as the HSBC S&P 500 ETF (HSPX), which comes with one of the lowest available TERs at 0.09 per cent. But being a newer fund, HSPX is much smaller and doesn't offer as much liquidity as the iShares fund. The SPDR S&P 500 ETF (SPX5) has a TER of 0.15 per cent and features in our Top 100 Funds list.
The Russell 2000 index also comes highly recommended - which provides exposure to a wider range of smaller companies, including many of the technology start-ups that have experienced meteoric rises in recent years. This index is more expensive to track, which leads to higher fees, but analysts say the enhanced performance makes the trade-off worthwhile. The db x-trackers Russell 2000 ETF (XRU2) is also worth looking at and has a TER of 0.45 per cent.
But an index to avoid is the Dow Jones Industrial Average, which, Peter Sleep, senior portfolio manager at Seven Investment Management, labels "illogical and out of date". He disapproves of its stock selection method, which ranks 30 companies by their market value as determined by a price-weighted measure instead of their share price, meaning Apple, which has a share price of around $600, doesn't even feature in it. A stock typically is added to the Dow only if the company has an excellent reputation, demonstrates sustained growth and is of interest to a large number of investors.
Another issue you need to beware of is accidental tax inefficiency. You need to look closely at the treatment of the withholding tax on dividends paid by an ETF's holdings, because on rare occasions where the stocks are traded in the US, you could be charged as an individual as well as at the fund level - and the US has a very aggressive tax regime. You should fill in W-8BEN form (ask your stockbroker to provide this). Withholding tax applied to dividends distributed by a US-domiciled fund will be subject to a generally higher rate than that applying to a fund domiciled in a European country.
Ursula Marchioni, director of iShares, warned that the two effects might "net out" or even favour the route of the Europe-domiciled fund. But if you do want to pursue the ETF road to the US, look at whether the fund has reporting and tax distribution status. If it has this, or is 'seeking' it, it will treat returns as capital gains, but if it does not it will be treated as income and will be subject to more tax.
It's well worth noting that ETFs domiciled in Luxembourg or Ireland do not levy withholding tax on dividends paid to UK investors. Most ETFs available to UK retail investors are domiciled in these centres, but you should check this out before investing to be sure you won't be vulnerable to this risk. All the ETFs recommended above are domiciled in these centres.
Currency risk is also a potential pitfall you need to be aware of when investing in these funds. Getting the timing wrong can lead to major losses, but there are a range of new funds that hedge this risk. John Fletcher, head of exchange traded products (ETPs) at Charles Stanley, says these tools push up fees but can be very effective, and recommends the iShares S&P 500 Monthly GBP Hedged (IGUS). With a TER of 0.45 per cent, it is only five basis points more expensive than its equivalent non-hedged fund, but with total net assets at £37.5m, it is dwarfed next to the standard iShares S&P 500 tracker which totals £6.5bn - which brings investors a comforting liquidity a smaller fund cannot provide. While its size may stifle liquidity, Mr Fletcher still recommends the hedged ETF as a worthy investment.
Top tips for US ETF investing
■ Consider which index is being tracked
■ Watch out for tax inefficiencies
■ Be aware of currency risk
■ Bigger funds are more liquid
■ Low fees mean less chance of performance error
Recommended US ETFs
| Fund | TER (%) | Where domiciled |
|---|---|---|
| iShares S&P 500 ETF (IUSA) | 0.4 | Ireland |
| SPDR S&P 500 ETF (SPX5) | 0.15 | Ireland |
| db x-trackers Russell 2000 ETF (XRU2) | 0.45 | Luxembourg |
| HSBC S&P 500 ETF (HSPX) | 0.09 | Ireland |
| iShares S&P 500 Monthly GBP Hedged (IGUS) | 0.45 | Ireland |
