Look beyond short-term rate rises when considering the US

The uncertainty in the market has been compounded by the possibility that the US central bank, the Federal Reserve, will raise its base interest rate at some point later this year. The interest rate has been at a record low of 0.25 per cent for nearly seven years, spurring economic activity by allowing companies to borrow cheaply and lowering mortgage repayments. Therefore, any upward movement in the rate is viewed by many as a negative for the US market.

Jim Wood-Smith, head of research at Hawksmoor Investment Management, points out that the US equity market has been tracking sideways since October 2014, when the Federal Reserve finally ended its quantitative easing (QE) programme and the easy money that had been flowing into the markets, raising the prospect of a rate rise.

Mr Wood-Smith says QE had been a major source of funds for US companies buying back their own shares, and buybacks were a major driver of US equity performance in 2013 and 2014 because corporate earnings growth slowed during that period.

With that funding now gone, a rate rise on the horizon and little signs of growing corporate earnings, Mr Wood-Smith says he doesn't expect the US market to do any better than track sideways for the foreseeable future.

The likelihood that the Federal Reserve will raise interest rates in the near future has long been known to market participants, though the exact timing of the rise is still subject to frenzied debate. However, Meera Hearnden, senior investment manager at Parmenion, argues that any rise is still not fully factored in to market expectations and, when the rate rise does come, she thinks "it will nevertheless surprise markets". Ms Hearnden adds that when the Federal Reserve raises the rate it will lead to an initial pullback in US equities.

However, after the experience of the taper tantrum in May 2013, when an unexpected announcement from the Federal Reserve that it would begin to reduce its QE programme led to a precipitous sell-off across global markets, Whitechurch Securities managing director Gavin Haynes expects the US central bank to approach the rate rise differently.

Mr Haynes says the Federal Reserve will "drip-feed rhetoric that will provide plenty of warning for when rates are to rise", which should mean that when the rise does occur any sell-off should not be too severe.

The consensus view is that when the rate rise happens the US banking sector will be the area of the market most likely to benefit. Mr Haynes said he had been adding exposure to the banking sector because they "could have the opportunity to increase margins between their deposit rate and the rate they lend at, when interest rates go up".

In previous rate rise cycles, cyclical sectors such as industrials and consumer discretionary stocks have performed well, according to Ms Hearnden. This was likely to be because a rising rate environment is normally one in which the US economy is growing strongly - and in which cyclicals outperform. However, Ms Hearnden warns the coming rate rise cycle will not be typical of previous cycles so "it is difficult to say if this will hold true in this unusual environment of policy tightening".

But experts have warned investors to steer clear of so-called bond proxies - stocks which have been bought as a surrogate for investing in bonds in recent years because of their high yields. The utilities sector is an example of this category.

However, commentators have become split on whether larger or smaller companies are likely to outperform when rates rise.

The argument in favour of large caps, says Ms Hearnden, is that they are "better equipped to deal with rising interest payments on loans". But Mr Wood-Smith argues that "the early stages of the up part of the interest rate cycle are typically associated with high economic growth and domestic earnings growth, favouring mid and small caps".

Whether you invest in small or large caps, the important point for US investing in the next five years is to stop paying attention to the short-term noise about when the Federal Reserve will raise its rate.

As Mona Shah, assistant fund manager and senior research analyst on the Rathbone Multi Asset portfolios, explains: "Rather than spending an inordinate amount of time second-guessing the Federal Reserve, we believe it is more productive to ensure portfolios are positioned to outperform over the next five years. Rates are almost certain to rise in that timeframe, and we believe the companies that can steadily grow their revenues and distributions will excel."

However, David Hambidge, director of multi-asset funds at Premier Asset Management, warns the high valuation on the US market means that "on any sensible investment horizon" the region is unlikely to outperform markets such as Europe and Japan. For Mr Hambidge the coming rate rise will make little or no difference, and he says investors need to look through it and concentrate on the high price they are currently paying for US equities.

Fund options

For many years the US equity market has been the poster child for passive investment advocates. The market is seen as highly efficient and it has proven exceedingly hard to find an active manager able to consistently beat it.

However, fund selectors are now arguing that the forthcoming environment, in which the US market may struggle or 'trade sideways', is one in which managers with proven ability as stock-pickers, and the ability to hold investments for the long term and ride out the short-term noise, may be able to thrive.

One such fund is Legg Mason Clearbridge US Aggressive Growth (IE00B19ZB102). Managed by Evan Baumann and Richie Freeman, the fund belies the Aggressive label in its name by taking a very long-term buy-and-hold approach to stocks its managers believe can grow strongly in the long term.

The fund is currently a favoured pick in the Rathbone multi-asset funds. Ms Shah points to the managers' early recognition of the potential for returns from biotechnology stocks as an example of their ability to pick long-term growth winners.

With returns on US equities likely to be relatively low through the next five years - experts have suggested annual returns of little more than mid-single digits - investors could consider an absolute return fund. James Calder, research director at City Asset Management, says he has invested in the RWC US Absolute Alpha Fund (LU1017298776) in several portfolios. He says the fund, which takes both long and short positions in US equities so can benefit if markets move up or down, has historically performed better than the index in falling markets and offers a lower volatility way to access the US market.

The nature of the fund, which is managed by Alex Robarts and Mike Corcell, means it will lag considerably in rising markets, as shown by its performance compared with the S&P 500 over the past five years. However, its outperformance in recent months, where it has gained money even as the market falls, shows the value of its absolute return approach.

For smaller companies exposure to US equities, Mr Haynes suggests Jupiter US Small & Mid Cap Companies (GB00BJT32C83). Although the fund is relatively new, having been launched little more than a year ago, Mr Haynes says its manager Robert Siddles built up a strong long-term track record running a similar fund at F&C. Although the fund invests in smaller companies, which are generally higher risk, Mr Siddles' approach centres around first and foremost avoiding capital loss, which means the Jupiter fund offers a cautious and therefore lower-risk approach to a higher-risk area of the market.

Mr Siddles also continues to run the investment trust he ran at F&C, which is now called Jupiter US Smaller Companies (JUS). It has not done well over one and three years, but beats its benchmark the Russell 2000 over five. Jupiter US Smaller Companies trades on a discount to NAV of more than 12 per cent and has an ongoing charge of 1.05 per cent.

The argument in favour of passive exposure to US equities has meant investors have a number of options available if they want a low-cost and heavily diversified approach to the market. If you prefer open-ended tracker funds, Ms Hearnden singles out Vanguard US Equity Index Fund (GB00B5B71Q71). She says the tracker "has one of the lowest charges relative to its peers and a low tracking error making it an attractive option."

Among exchange-traded funds (ETFs), which are listed on the stock market, Mr Haynes says he would opt for iShares Core S&P 500 ETF (CSP1).

For more passive options, check our IC Top 50 ETFs list which includes five US funds.

Suggested US funds

Source - FE Analytics

*The iShares annual charge is the total expense ratio (TER)

Note: All charges are taken from the clean fee share class