Low-cost passive funds have been a good way to invest in the US in recent years, as active fund managers have struggled to outperform the main benchmarks such as the S&P 500 index. But tracking an index could now expose you to more risk than an active fund if the US market falls, so it could be time to switch your passive US exposure away from the most popular indices.
Over the past 10 years, exchange traded funds (ETFs) tracking the S&P 500 index have generated better returns than many active funds that try to beat the index, meaning passive funds have been a good option for allocating to the US. For example, over five years iShares Core S&P 500 UCITS ETF (CSPX) has returned 219.1 per cent, far more than the Investment Association North America sector average return of 163.9 per cent.
ETFs tracking the tech-focused Nasdaq 1000 index have also benefited from a sharp upwards rally. For example, over 10 years the index has returned 420.02 per cent and PowerShares EQQQ Nasdaq-100 UCITS ETF (EQQQ) has returned 391.03 per cent.
But a technology-fuelled rally has propelled the main US benchmarks to record highs and, unlike active funds, which can choose to avoid certain overvalued stocks, ETFs tracking them will be fully exposed to any market fall. So you might want to be more targeted in your passive US exposure to dodge the risk of a correction.
Adrian Lowcock, investment director at Architas, says: "If you buy a tracker fund or ETF, you are buying the whole market and getting the expensive bits as well as the cheaper areas. Just because something is expensive doesn't mean there are no value opportunities. When it comes to areas of the US market, such as technology, for example, stock selection is now key to success."
Jason Hollands, managing director at Tilney Group, adds: "If investing in the US now I wouldn't do what many of us have historically – buy a US tracker fund. That has been the almost default way for US investors to access the region. But it might not be the right strategy now if you think that this market is pricey and at risk of a correction."
Instead of a broad market ETF, he suggests buying an alternatively-weighted option such as Powershares FTSE RAFI US 1000 UCITS ETF (PRUS), which tracks the value-weighted FTSE RAFI US 1000 index. This index weights constituents by fundamental factors including sales, cash flow, book value and dividends rather than market capitalisation, which means it stands more of a chance of dodging overvalued shares.
Mr Hollands says: "The process means you have less exposure to the stocks trading at premium valuations, and more of a skew towards companies that are profitable and cash-generative."
Another option is to track a factor index such as the S&P 500 Value. This is composed of stocks with lower price tags that are more tilted towards cyclical areas of the market such as financials, which could do well if there are interest rate rises.
ETFs tracking this index include UBS MSCI USA Value UCITS ETF (UC07), which over 2016 outperformed the S&P 500 and Nasdaq 100 indices. If markets fall it is likely to perform in a different way to broad benchmarks, although over the long term it has lagged broad market indices.
Oliver Smith, portfolio manager at broker IG, says: "We think some sterling-hedged exposure to the US makes sense, as on a longer-term view sterling looks decent value. iShares S&P 500 GBP Hedged UCITS ETF (IGUS), which recently lowered its ongoing charge to 0.2 per cent, is our preferred way to do this."
Areas to avoid
The most risky areas for passive US investors include smaller companies and technology stocks, which have performed strongly in the past few years. Both are areas in which there are big winners and big losers, meaning it is better to invest in these via an active fund which can be more selective than a passive fund that tracks the entire index.
"Tech stocks are the riskiest bit of the market," says Mr Hollands. "There has been such a strong rise in the Nasdaq 100 this year and parts of the small-cap market are very high risk, too. We are now on a path of gradual monetary tightening. In the past few years, huge amounts of liquidity have gone into the market and propelled riskier stocks higher. When that liquidity is withdrawn, even if that process is slow, those stocks will be the most vulnerable."
Mr Smith adds: "The Russell 2000 was a great beneficiary of the post-US election Trump Trade, but we would caution against investing there due to stretched valuations. The Russell 2000 index now trades on 47 times its historic earnings and 30 times this year's earnings."
ETFs tracking this index include SPDR Russell 2000 US Small Cap UCITS ETF (R2SC), Lyxor Russell 2000 UCITS ETF (RU2K) and db x-trackers Russell 2000 UCITS ETF (XRSG).
ETFs tracking the Nasdaq 100 include iShares NASDAQ 100 UCITS ETF (CNX1), Amundi ETF NASDAQ-100 UCITS ETF (ANXG) and Lyxor Nasdaq-100 UCITS ETF (UST).
