QE watch: the funds set to benefit

A turning point and how to play it

Since 2008, the UK, US, Japan and Europe have all taken turns to binge on cheap money via QE. The US was first, starting its programme in 2008 and followed by the UK the following year. Japan and Europe launched their own easing programmes in 2013 and 2015, respectively.

In each of those markets QE has resulted in similar patterns: depressed (and sometimes negative) bond yields, soaring asset prices and weaker currencies. It has also had an impact on sectors, with export-focused sectors and those returning higher yields tending to outperform.

QE is not the only explanation for these patterns, but it is one of the clearest investment narratives around and well worth paying attention to when making allocation decisions. Tom Becket, chief investment officer at PSigma, says: "If you look back at the past six years QE and central bank policy has been the predominant driver behind market performance across Europe, Japan and the US."

It is particularly important to sit up and listen to central banks now as they head in opposite directions. After extended rounds of QE, the UK and US are weaning themselves off cheap money and finally starting to raise interest rates. Meanwhile, the European Central Bank (ECB) will vote on whether or not to extend QE at its meeting on 3 December and Japan could face more easing, too.

Currency issues

One of the ways to use QE in your investing is to opt for currency-hedged share classes. Currencies generally slide in value on the announcement of QE programmes. In fact, weak currencies help QE to do its job, by making a country's exports cheaper and more appealing to foreign investors. The weakening function is partly because the increased volume of currency in the system reduces the value of the existing notes. It is also because the combination of QE and low interest rates sends money rushing out of the country into currencies such as the dollar which offer better returns.

Opting for a currency-hedged share class protects you against investing in weak currencies and during QE this can be a sensible strategy. Last year, hedged share classes of European funds available on main platforms outperformed unhedged share classes. In European equities, the JPMorgan Europe Dynamic ex UK A hedged fund (GB00B42T7F64) returned 8.3 per cent compared with 0.5 per cent in 2014 and in the year to date returned 12.9 per cent against 3.2 per cent for its unhedged peer.

Meanwhile in Japan, hedged funds performed vastly better in 2014 but the difference had tailed off slightly by the beginning of 2015. In open-ended funds Schroder Tokyo A Hedged Acc (GB00B91RJ05) performed better than Schroder Tokyo Acc (GB0007650640) in both 2014 and the year to date. Exchange-traded funds told a similar story. Db x-trackers MSCI Japan index UCITs ETF (DR) 6C hedged to GBP (XMJG) outperformed the unhedged ETF significantly in 2013 and 2014, at the start of the QE programme, but underperformed slightly in the year to date in 2015. iShares MSCI Japan GBP Hedged UCITS ETF (IJPH) also returned more than iShares MSCI Japan UCITS ETF (CPJU) in 2014 but not the following year.

Adam Laird, passive investment manager at Hargreaves Lansdown, says: "An expansion of the QE programme this year looks likely, which could boost euro assets, but could also hit the euro. In this regard, GBP hedged European equity funds might be a good call. There are two options here: db x-trackers MSCI EMU Index GBP Hgd UCITS ETF (XD5S) and UBS ETF MSCI EMU GBP Hgd (the UC60 ETF reinvests income and UC59 distributes it). The db x-tracker is the cheaper option."

Viktor Nossek, director of research at WisdomTree Europe, says: "QE programmes by the ECB and the Bank of Japan remain a key theme dominating both Continental Europe and Japanese equity markets and investors' approach to managing currency exposure and investments.

"By hedging exposure to the potential currency weakness as a result of QE, investors may more fully benefit from the bullish sentiment in European and Japanese equity markets driven by a QE-led environment."

Japan is currently remaining tight-lipped about whether more easing is on the horizon but a decision is expected at its January policy meeting.

Using QE to select Europe sectors

Beyond currency hedging considerations, some argue you should choose funds focused on export-focused countries. According to Tilney Bestinvest's latest premier selection fund report: "If the euro remains weak, the sector's exporters, such as pharmaceuticals, consumer goods, automobiles and capital goods are among the companies to focus on." The fund house likes Threadneedle European Select (GB00B8BC5H23), which focuses on companies with consistent above-average growth rates as a core choice.

James Butterfill, at Tilney Bestinvest, says: "QE has certainly been beneficial for equities and one of the knock-on effects is that it has also significantly weakened the euro, so more export-orientated nations have typically benefited." However, the recent downturn in demand from China and emerging markets arguably presents a risk for export-orientated countries. Sam Cosh, manager of IC Top 100 fund European Assets Trust (EAT), which focuses on smaller companies, argues that smaller, domestic facing stocks could benefit from a domestic recovery and a QE injection. He says: "The market leadership has moved away from international growth towards domestic growth in Europe. Small-caps are more likely to be domestically exposed and a recovery will be very important for them."

Of the popular hedged fund options, Artemis European Opportunities I Hedged (GB00B6WFCS60) aims to generate long-term growth through European equities outside the UK but it invests in a range of shares, fixed-interest securities and derivatives. JPM Europe Dynamic ex UK C Hedged Acc GBP (GB00BCV7MM92) has 95 holdings and is relatively evenly balanced between giant, large and medium-cap stocks.

Performance of hedged European and Japanese funds relative to unhedged (%)

Changing your investment style when QE ends

In contrast to Europe and Japan, the US has turned off the QE tap and is raising rates, meaning the dollar could be set to strengthen and a value-focused investing style could come back into favour.

Value investing looks for companies with strong balance sheets that are undervalued or out of favour, unlike a growth approach which looks at companies with rising share prices. Jeremy Beckwith, director of manager research at Morningstar, says: "Generally in the past five years in the US, growth funds have done better than value funds during QE, but QE has not actually worked in terms of boosting the real economy. QE lifts all boats and you are left with stock markets with very high valuations across the world and not a lot of prospect for growth."

QE critics say that cheap borrowing enables companies at all ends of the market spectrum to take on cheap debt and even buy back their own shares, pushing up their value and inflating their share price. An end to cheap borrowing via increased rates means those companies have a tougher time servicing that debt and face weaker balance sheets as a result.

In recent years the S&P 500 Value Index has significantly underperformed the S&P 500 Growth Index, returning 0.5 per cent in the year to date compared with 9.15 per cent. In 2014 it returned 19.3 per cent compared with 22 per cent.

But James Butterfill agrees that this could be a less appealing strategy now. He says: "The growth style in general is very expensive now."

He says the shift will alter sector performance, too. "During the long period of QE in the UK and US the sectors that performed best were those like utilities, property real estate investment trusts and typically more defensive sectors. This was because QE pushes down yields and leads people to look for assets with a higher return, rather than bonds," he says.

"You are likely to see a rotation around the first Fed rate hike and sectors likely to perform better will be those exposed to the cyclical economy, so areas such as banks, engineering companies and industrials."

What does that mean for US funds?

Tilney Bestinvest's latest fund selection report highlights Dodge & Cox Worldwide US Stock (IE00B50M4X14) and Aviva Investors US Equity Income II (GB00BCGD4N78). The Dodge & Cox fund aims to invest in temporarily undervalued equities and focuses on factors including financial strength, economic condition, competitive advantage and company management. Over 25 per cent of the fund is invested in banks, which many argue will perform better in a rising rate scenario, and 14.8 per cent of the fund is invested in healthcare. Chelsea Financial Services also names it as one of their favoured US funds.

The Aviva fund has an income focus, but also looks for undervalued companies with strong balance sheets and the ability to perform well over the long term and pay healthy dividends.

Chelsea Financial Services also holds value-focused Fidelity American Special Situations (GB00B89ST706), which was added to the Investors Chronicle Top 100 funds in September. The fund is one of the only active funds to have significantly outperformed the S&P 500 over a one, three and five-year basis. Manager Angel Agudo aims to find at least 30 per cent of upside potential in any stock, but also keeps an eye on the downside risk of stocks, maintaining a defensive element within the portfolio. Mr Agudo has less of the fund in financials than other value funds, at 15.4 per cent, and more in consumer cyclicals, at13.6 per cent. The portfolio is concentrated, with only 53 holdings in total.