US is not a Brexit haven, but could be worth the price

A move to US stocks, which are far less affected by the vote for Brexit than the home market, may seem sensible. But you could be taking on more risk by moving into US equities than by sticking with the FTSE 100.

The US has a number of problems - especially for UK investors. A major issue for UK investors buying US equities is the risk of buying expensive dollar-denominated assets with a weak pound, and losing out on both sides of the trade. After the referendum on 23 June the pound fell to a 31-year low against the dollar and Jason Hollands, managing director at Tilney Bestinvest, says: "When you're in the eye of the storm here people think they should put more money into the US, but you could be doing that at a time when sterling is at maximum weakness against the dollar."

That is even more of an issue if you consider how expensive US equities already are. The US market has been on a quantitative easing (QE)-fuelled upward surge and the S&P 500 is now up almost 250 per cent in sterling terms since its low of 2009. The worry is that stock prices are ratcheting upwards even as earnings are declining, fuelled further by companies using debt to buy back shares and further inflate valuations. And earnings growth is slowing and profit margins are weakening.

"The US started to pick up safe haven status a few years ago, but since then you've seen massive divergence reminiscent of the late 1990s between earnings which are falling and valuations which are continuing to climb," says Guy Monson, chief investment officer at Sarasin & Partners. "Add to that the fact that you are seeing corporate debt increase for reasons including share buybacks, and you really have to ask whether now is the time to be classifying America as a safe haven. The US is yesterday's trade."

Ben Seager-Scott, director of investment strategy at Tilney Bestinvest, adds: "If the US market is already priced to perfection, even if all of your theories are right and your growth projection is bang on, you end up making no money at all."

This is precisely the opposite situation to the FTSE 100, which has taken a beating and looks cheap, while certain of its constituents will benefit from a weaker sterling boosting the competitiveness of their exports.

The lesser of many evils?

However, if your main priority is holding on to your money and taking a defensive global position, the US could still be a good bet and its price could be worth paying for security of income, particularly compared with the uncertain future faced by UK stocks.

Darius McDermott, managing director at Chelsea Financial Services, says: "In a world of uncertainty, investors tend to move to the strongest place, and the US is arguably that place. The dollar is seen as a safe haven currency and the US economy, while not perfect, is arguably more solid than any other in the developed world."

US growth has been slowing, but it still looks stronger than other markets. "I'm genuinely not sure what market looks good now," says Rebecca O'Keefe, head of investment at Interactive Investor. "But in the US you've got a market moving towards full employment levels and an economy doing reasonably well versus the UK, which is a market facing significantly larger complications."

Adrian Lowcock, head of investing at AXA Wealth, believes that US "valuations are high but that the market currently deserves its premium, particularly compared with everywhere else. It feels as though we have got these premiums on the back of QE and risk aversion, but given everything happening in the world elsewhere it doesn't feel as though we're at an inflection point just yet".

And there are plenty of commentators who argue that the US isn't just good for steady Eddy stocks, but also for the most exciting names of tomorrow. The 'FANG' stocks - Facebook (FB:NSQ), Apple (AAPL:NSQ), Netflix (NFLX:NSQ) and Google (GOOGL:NSQ) - are US-listed and arguably the most high-profile tech stocks to invest in.

New disruptive tech stocks such as Tesla (TSLA:NSQ), meanwhile, are located in Silicon Valley. "The US is jam-packed full of exciting, entrepreneurial companies - both large and small," says Mr McDermott. "It's also home to a large proportion of the world's healthcare and technology companies, many of which have products and services that are required no matter how bad things get."

How to invest

Finding an active manager who can outperform the US market is tricky. Over five years the average Investment Association (IA) North America equity fund has returned 85.3 per cent, falling far short of the S&P 500's 111.5 per cent return, and only a small group of funds have outperformed that index. Fidelity American Special Situations (GB00B89ST706) is one of those, while one investment trust - JPMorgan American Trust (JAM) - has beaten the index over a 10-year period.

There are reasons to back an active fund in the US, though. In an overvalued market with potential pitfalls, it can be a good idea to follow a manager you trust to navigate through the froth, and stick to a specific investment style and strategy. "The last thing you need in US equities at the moment is to pile into a tracker," says Mr Hollands. "Normally we like S&P 500 trackers, but I think that at the moment you don't want to be in the market in an indiscriminate way.

"You've got to be really picky and not just take a view on the overall market. A tracker is a bull market investment and it does not feel at all like we're going into a bull phase for US equities or global equities. You need to be going for high-quality growth stocks without highly leveraged balance sheets."

US equity managers tend to either take a defensive strategy and pay a premium for bond-like stocks, or opt for higher-risk but cheaper value stocks. The risk in taking a defensive position is that these income payers which have been pushed up by investors seeking yield, could be the heaviest hit stocks in the event of a rate rise and a sell-off.

But buying value stocks could leave you with a basket of cheap stocks which are cheap for a reason. Until last month, the general consensus was that it is a good time to switch from the pumped-up 'bond proxies' to unloved value stocks that looked ready for a turnaround. But the recent volatility appears to have put the kibosh on that trade for many, who are flocking back to safety.

Mr Lowcock says a defensive holding in a US equity income fund such as JPMorgan US Equity Income (GB00B3FJQ599) should be your "first port of call. These are likely to be the most expensive stocks, but an active manager should be able to avoid the worst of that," he says.

This fund invests in high-quality, dividend paying companies offering good long-term income streams and some capital growth. These are stocks that consumers will continue to need and buy, no matter what happens in the outside world. Examples include Johnson & Johnson (JNJ:NYQ), tobacco company Altria (MO:NYQ) and pharmaceutical company Pfizer (PFE:NYQ).

Mr McDermott also recommends the fund, but it has underperformed the S&P 500 over the long term.

"It was our belief that volatile times would have triggered a rush to safe-haven assets," says Clare Hart, manager of JPMorgan US Equity Income. "We expect that our positioning will benefit from this flight to quality, at least on a relative basis. Our positioning across the board is in lower volatility and less cyclical holdings. Even within financials, our exposure is primarily domestically focused regional banks and insurance companies. On a relative basis, these holdings should outperform more globally-oriented financials."

Fidelity American Special Situations looks for undervalued opportunities so is less likely to be invested in overvalued income stocks. It has outpaced the S&P 500 by 20 per cent over five years and beats it over three years too - a rare find for an actively managed fund. Manager Angel Agudo took over the fund in December 2012 and runs a concentrated portfolio of 52 stocks. He has recently increased its holding in brewing company Molson Coors (TAP:NYQ).

The fund does hold stocks like Pfizer, which accounts for 4.4 per cent of its assets, but has more value names. Analysts at Morningstar say: "The fund's standard deviation is slightly higher than that of its peers, but investors have been rewarded for the risk, as risk-adjusted returns are high."

This is different to a more defensive approach but has helped the fund return 125.7 per cent over five years, compared with 111.5 per cent for the S&P 500 Index.

Mr Agudo says the portfolio has recently shifted towards an overweight to IT as a result of the market moving against older tech companies, which have retained strong balance sheets but experienced falling share prices. "I initiated a position in IBM (IBM:NYQ), and increased my holding in Oracle (ORCL:NYQ)," he says. "Other key holdings within tech include Microsoft (MSFT:NSQ), Cisco (CSCO:NSQ) and VMware (VMW:NYQ).

Mr Agudo is also considering buying more energy stocks due to the slump in oil prices but is "waiting to see a normalisation of the oil price before increasing positions in this sector".

Source: Morningstar. Performance as at 1 July 2016

Among closed-end funds JPMorgan American Investment Trust looks for high-quality stocks in the core market and has a large allocation to IT - over 26 per cent - and 16.9 per cent in healthcare. The trust has underperformed the S&P 500 over shorter timeframes, which its managers say is due to "weak stock selection in the information technology and energy sectors".

A value-focused fund recommended by brokers Stifel and Cantor Fitzgerald is Gabelli Value Plus+ Trust (GVP), which takes an out-of-favour value approach and is currently at a wider-than-average discount of 9.7 per cent. "With the US market trading close to historic highs we believe a defensive approach, such as Gabelli Value Plus+ takes, is appropriate," says Stifel. "We are encouraged that, despite the headwinds, the team has remained true to its philosophy and that performance has been close to the Russell 3000 Index since the trust has been fully invested."

The trust only launched in February last year and sharply de-rated at the start of this year. But Monica Tepes, investment companies analyst at Cantor Fitzgerald, argues that it is a very strong offering run by a prestigious US manager, and expects performance to start coming through.

The trust's manager is based in the US, a key benefit in the highly liquid US market. Gabelli Value Plus+ would also be a differentiated holding in a portfolio as it has a mid- and small-cap bias, typically having little in common with the S&P 500.

Source: Morningstar. Performance as at 1 July 2016

Smart passive funds

Even diehard active management enthusiasts are willing to embrace passive funds when it comes to the US and there are very solid arguments for going down this road.

The charges on these funds are lower, with the lowest-cost option, Vanguard S&P 500 UCITS ETF (VUSA), available for an ongoing charge of just 0.07 per cent.

Even more importantly, you could find yourself taking home better returns than an active fund underperforming the main index, because the US is an area where active managers consistently struggle to beat the mature index. "It's the one place where I'd countenance buying a tracker," says Mr McDermott.

When it comes to US equity investing an ETF tilted towards particular types of stocks could be a better bet than a broader index tracker. These factor ETFs take their methods and ideas from the realm of active management, but offer the style at a much lower cost. Just like an active fund, these ETFs offer a way to invest in, for example, the most stable income-paying stocks or the least loved value stocks.

A quality factor ETF is a good way to get exposure to US stocks with recurring cash flow, low debt levels and good income characteristics.

Mr Seager-Scott highlights PowerShares FTSE RAFI US 1000 UCITS ETF (PRUS). Instead of replicating a market-cap-weighted index, this fund isolates stocks on the basis of total cash dividends, free cash flow, total sales and book equity value in order to screen out poorer quality names. The index is designed to be less vulnerable to cyclical market trends and has a yield of 1.67 per cent. Over five years it has generated almost 100 per cent and over six months is also in positive territory.

Another way of opting for steady dividend growth is to choose a dividend-focused ETF. The WisdomTree US Quality Dividend Growth UCITS ETF (DGRG) launched last month and seeks high-quality income-paying stocks. It tracks an index that selects stocks based on company metrics associated with future dividend growth potential. Those include long-term earnings growth expectations and quality factors, including average return on equity and return on assets figures, to determine which firms are generating profits most efficiently. The strategy is a new one so remains untested, but is based on WisdomTree's in-house income-focused strategy.

SPDR S&P US Dividend Aristocrats UCITs ETF (USDV) is another income-focused ETF that looks for stocks that have increased dividends for 20 consecutive years. Its focus on consistency means you end up with a conservative portfolio of income-paying stocks and the portfolio is relatively small, with just 107 holdings. However this fund is likely to be defensive and the strategy has outperformed the S&P 500 over the medium term. Over one year it has returned 29.9 per cent compared with 18.9 per cent for the index, but over three years it underperforms the index returning just over 50 per cent compared with 53.4 per cent.

If you want to avoid expensive stocks and are happy to take the risk of an out-of-favour style then opt for a value-slanted index. James McManus, fund analyst at Nutmeg, says: "High income and dividend equities have been bid up by investors searching for yield over the previous cycle. Dividend stocks are susceptible to crowding risk in the current environment, due to low interest rates having made them particularly attractive relative to bonds over the past couple of years.

"We have retained a value tilt in portfolios via allocation to the MSCI USA Value Index. While some areas of the US market are expensive, value by definition remains attractive from a valuation perspective, and despite being well supported by recent flows is still considered somewhat of a contrarian play having been out of favour for some time."

Mr McManus suggests UBS MSCI USA Value UCITS ETF (UC07), which provides a value tilt within large-cap US equities. It tracks the MSCI USA Value Index, and the selection criteria for its constituents include book value to price, 12-month forward earnings to price and dividend yield.

If you want to hedge out the impact of any sterling appreciation from here you could also opt for db x-trackers S&P 500 UCITS ETF (XDPG). Mr McManus says: "It is the market leader in price, delivers the lowest total cost of ownership for Sterling hedged exposure, and has seen its assets grow over the past 12 months."

Performance (cumulative total return %) of passive funds

Source: FE Analytics as at 30.06.16

Active fund performance

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