Avoid US equities at your peril

Investor concerns include President Donald Trump's failure to push through many of the reflationary policies he had pledged before the election and interest rate rises which could trigger an equity sell-off. 

But with such a large chunk of global assets invested there, you will miss out if you do not have some exposure to this market. The US is also enjoying its third longest period of economic expansion since 1850 and its economy is forecast to grow by 2.1 per cent this year and next, according to the International Monetary Fund (IMF). Unemployment is historically low and companies are reporting strong earnings.

"I wouldn't tell anyone to avoid the US," says Jason Hollands, managing director at Tilney Group. "It is the biggest equity market in the world and there are a raft of fantastic companies based in the US. It's also the leading market for areas such as technology and healthcare, so avoiding it doesn't make any sense for a long-term portfolio."

Adrian Lowcock, investment director at Architas, adds: "Avoid the US at your own peril. It may be an expensive market but if growth continues – and we've yet to see any concrete sign that it won't – you will miss out on returns by not being invested."

Index-beating funds

The US is not an easy market for active fund managers to beat, but many of the best-performing managers that have achieved this over the past 10 years invest in large-cap, high-growth technology and high-quality consumer staples stocks. And although these parts of the market are on high valuations, a good fund manager should be able to differentiate the quality from the froth.

One of the best-performing funds in the Investment Association North America sector is Baillie Gifford American (GB0006061963), which has returned 256.3 per cent over 10 years, well ahead of the S&P 500 index's return of 200.5 per cent. The fund is concentrated, typically holding between 40 and 60 stocks, and it has a very low turnover. Its managers are Tom Slater, who also runs top-performing technology-flavoured Scottish Mortgage Investment Trust (SMT), Gary Robinson and Helen Xiong. They invest for capital growth and buy US businesses they believe have unique strengths. The fund has 30.5 per cent of its assets in consumer discretionary stocks and 24 per cent in technology companies such as Amazon (US:AMZN), which makes up 8.7 per cent of the portfolio, and Tesla (US:TSLA), which makes up 8.2 per cent.

Ben Gutteridge, head of fund research at Brewin Dolphin, says Baillie Gifford American's managers are good at spotting the technology innovators that will provide long-term capital growth, and that there could be good reasons for technology companies' higher share price multiples.

"Technology companies can trade on higher multiples than traditional businesses because the margins are greater and there is less capital intensity to their businesses," he says. "History tells us that valuations are rich, but there are many other reasons to suggest that these companies could trade on even higher multiples."

Schroder US Mid-Cap (GB00B7LDLV43) is another strong performer over the long term. The fund is run out of New York by Jenny Jones and a team of analysts, who focus on small- and medium-sized companies. The team categorises stocks in three groups: 'steady eddies' or less cyclically-sensitive stocks, 'mispriced growth' stocks where the market has not fully understood the company's earnings potential, and recovery stocks.

Over 10 years, the fund has returned 247.06 per cent against 219.96 per cent for the Russell 2500 index.

FundCalibre says: "It's the manager's stock-picking prowess, as opposed to sector allocation, that has formed the foundation of this fund's success. The fund is set up quite cautiously with Jenny's three-bucket approach, and consequently holds up well in tough markets."

Mr Hollands likes Loomis Sayles US Equity Leaders (GB00B8L3WZ29) because it has "a high exposure to technology and a very good track record of being defensive in down market conditions. The fund's main focus is on quality growth stocks, which means that its technology holdings are not very speculative, high-risk technology names."

The investment team of seven that runs this fund uses a rigorous seven-step process to create a concentrated portfolio. They do not look at price-earnings (PE) ratios, instead favouring metrics that indicate a company's potential to deliver a strong return on capital and invested capital, including top-line growth, free cash flow and margins.

Loomis Sayles US Equity Leaders' holdings include Amazon, which accounts for at 7.2 per cent of assets, Facebook (US:FB), which accounts for 5.2 per cent and Visa, (US:V) which accounts for 5.2 per cent.

Better value stocks

One of the main risks of investing in higher-risk growth sectors such as technology or expensive sectors such as consumer staples is that they could be negatively affected by a rise in interest rates. Low rates have resulted in low bond yields, pushing investors into equities and up the risk scale in a hunt for yield. A shift in interest rates could lead to a rise in bond yields, meaning that some investors ditch equities for bonds and share prices fall.

An alternative to areas vulnerable to rate rises is stocks that could benefit from a change in rates or the economic cycle, and you can get exposure to these via funds focused on cheap or overlooked value-style stocks. These types of share should be less expensive and could perform well if there are interest rate rises with, for example, cyclical sectors such as financials starting to perform strongly again.

Funds that invest in these include Dodge & Cox Worldwide US Stock (IE00B50M4X14), a contrarian fund that allocates heavily to cyclical sectors such as financials and diverges strongly from the make up of popular US benchmarks. Its managers takes a long-term view and invest in companies they think are undervalued by the wider market. This view has paid off over the long term but resulted in periods of sharp under performance, too.

Over five years the fund has returned 159.1 per cent, beating the S&P 500 by more than 20 per cent. But during years when its value style has been out of favour, including 2014 and 2015, the fund has tended to underperform.

"The fund is known for sticking with contrarian plays until they pay off, as the former Hewlett-Packard did in 2012 and 2013 after a prolonged slump," says research company Morningstar.

Dodge & Cox Worldwide US Stock has 27 per cent of its assets in financials stocks, a much larger weighting than the S&P 500 index's 14.5 per cent. The fund's largest holdings include Bank of America (US:BAC) and Wells Fargo (US:WFC), which each account for 3.6 per cent of assets, and Capital One Financial Corporation (US:COF) which makes up 3.4 per cent of assets. This weighting had been detrimental to performance but the fund performed particularly strongly in 2016, when cyclicals including financials and energy stocks experienced a strong bounce back. In the 2016 calendar year, Dodge & Cox US Stock returned 45.9 per cent compared with the IA North America sector average of 29.3 per cent and 32.7 per cent for the S&P 500.

Mr Gutteridge says: "The banking sector will continue to enjoy less burdensome regulation, which will hopefully free up capacity for more lending. There is a net interest margin story and more scope for interest rates to move higher, which benefits banks as they can pass that onto customers."

There is also a good operational story as the banks should benefit from an ongoing economic recovery.

Another value-focused fund that is overweight financials is Fidelity American Special Situations (GB00B89ST70). Like Dodge & Cox Worldwide US Stock, it performed strongly in 2016 and over the long term has also beaten the S&P 500. Over five years the fund has returned 150.5 per cent compared with 136.6 per cent for the S&P 500 index.

Its manager Angel Agudo invests in undervalued companies that have fallen out of favour, although he also takes into account the potential downside risk of a company. The fund is overweight financials, energy, industrials and technology.

Value-style investing is likely to mean you are invested in less expensive stocks, but these are more likely to be hit by political risk and in recent years have lagged growth stocks by some margin.

"The more legislation Trump is able to push through, the better value stocks are likely to perform," says Mr Gutteridge. "Following the election result, banks and energy stocks went on a tear, but since the start of 2017, when markets have woken up to the fact that Trump has not been able to push through as much as they thought, these trades have fallen back. Politics is going to be a dominant feature for value investing. However, a lot of the value names, particularly those stocks in the industrial and energy sectors, are geared into the global economic recovery, too."

Mr Hollands adds: "The question you have to ask with value investing is whether or not it is going to come good and perform again. The ball has now been in the court of quality growth stocks for many years. I would still stick to quality growth stocks, which can generate their own growth, and are not just cyclical plays."

Equity income funds

A relatively lower-risk way to invest in the US is an equity income fund where the dividends you receive act as a buffer against stock market falls.

Options include The North American Income Trust (NAIT), which yields 3.1 per cent, in contrast to the S&P 500's 2.02 per cent yield, and has experienced strong growth since managers Ralph Bassett and Fran Radano started running it in June 2015. They invest in cash-generative companies that are able to reinvest in their businesses and pay sustainable dividends.

Over three years, the trust has made a share price return of 63.47 per cent, ahead of the Association of Investment Companies (AIC) North America sector average of 45.13 per cent, but behind the S&P 500's 68.95 per cent return.

However, over one year the trust has beaten the index, suggesting that its new investment approach is working.

The trust aims for above-average dividend income and capital growth, primarily from US and some Canadian equities. It can also hold fixed income assets, and write covered call or put options to supplement income - up to 20 per cent of the portfolio may be covered by derivatives. The trust can also have gearing (debt) of up to 20 per cent of its net assets.

Fund performance