Prepare for volatility with US-light global funds

However, there is now a strong case for prudence at this late stage in the market cycle. An escalating trade war, companies’ high debt levels and concerns about worldwide economic growth are some of the reasons why investors should check that their portfolios are well diversified, putting them in a better position to mitigate future volatility.

For some professional investors, this has meant going against or entirely avoiding the US market. For example, James Clunie, manager of Jupiter Absolute Return Fund (GB00B6Q84T67), has been shorting US equities – betting on them falling – so this fund will benefit if the specific shares he has done this to fall in price. And Seneca Investment Managers cut its funds' entire exposure to US equities last year in the belief that this market would suffer most during a crash.

Continued strong returns from the US market mean that these approaches could detract from these funds' performance at the moment. So while US markets continue to rise, one way to diversify away from them without sacrificing too much return could be to invest in a global equity fund with lower US exposure than global indices such as MSCI World. 

Many UK investors have recently favoured global equity funds, investing more than £4.5bn in the Investment Association (IA) Global fund sector on a net basis over the 12 months to the end of June 2019. But US equities tend to make up a significant chunk of global markets and currently represent 55.5 per cent of MSCI World index. This is reflected in the allocations of many global equity funds because active fund managers are judged on how they perform versus their benchmark index and many of them have built up high levels of exposure to US equities. And US-heavy global equities funds have done well in recent years – eight out of the 10 best performing funds in the IA Global sector over the past five years to the end of July had 50 per cent or more of their assets in the US.

However, US stocks look expensive on various metrics following such strong performance, potentially limiting future returns and meaning that their prices may have a long way to fall if markets become volatile.

Daniel Pereira, investment research analyst at Square Mile Investment Consulting and Research, notes that some global equity managers' funds have less exposure to the US because share prices seem high and they “naturally tend to avoid such expensively valued areas”.

Investors also need to be aware of the risk of inadvertently duplicating their investments. If you already hold US equity funds but simultaneously invest in global funds with heavy US allocations, you are likely to replicate some exposures. This might not be a problem when the US is performing well, but could increase your losses in the event of a market fall.

Some global equity income fund managers also have big US allocations, but this can be at the expense of yield.

“The US market has historically been relatively low-yielding when compared with many other countries,” explains Mr Pereira. “Therefore, income-seeking managers generally find more attractive opportunities outside the US.”

Shane Balkham, chief investment officer at Beaufort Investment, adds: “The US represents the largest portion of the majority of global funds, which has been beneficial recently as the US market has been strong. However, having less reliance on the US in your global funds is not wholly bad and should provide better diversification. Hopefully a direct allocation to US equities will have [already] done well for a portfolio.”

So investors looking for diversified equity exposure or greater potential for income should consider investing in global funds with lower US exposure. Markets outside the US have also performed well this year, making life easier for the managers of global funds with lower US exposure. However, conditions could remain favourable for the US for some time, meaning that their returns might not be as good as broad global indices or global funds with higher US allocations. “In the current market environment with modest economic growth, accommodative central banks and subdued inflation expectations, growth stocks such as technology companies should continue to perform well," says Edward Park, deputy chief investment officer at investment manager Brooks Macdonald. "This makes an underweight position to the US equity market a risk.”

And lower US exposure does not guarantee that a fund will perform differently to that market because developed markets can be highly correlated. "If the US stock market falls apart, the rest of the world would not be immune," says Gill Hutchison, research director at fund rating company The Adviser Centre.

Global growth with lower US exposure

Delivering strong growth while avoiding the US has not been easy, but Sanlam Global High Quality Fund (IE00BYV7PR98) has managed to do this. It focuses on companies with predictable revenue growth and the ability to produce sustainable economic value. It might suit investors who feel reluctant to reduce their US exposure too drastically just yet: major US technology companies Alphabet (US:GOOGL) and Facebook (US:FB.) are among its 10 largest holdings and it had around 41 per cent of assets allocated to the US at the end of June. But this is well below MSCI World’s 55.5 per cent allocation to US equities, and the fund also had a 21 per cent weighting to Europe. German pharmaceutical company Bayer (Ger:BAYN) has been one of its stronger performing holdings in recent months.

Sanlam Global High Quality is fairly concentrated with just 32 holdings and its managers, Pieter Fourie and William Ball, do not seek to stay in line with any particular index. This means that if US equities become more or less attractive in future they are free to adjust their allocations accordingly.

If you want to deviate further from the allocations of global indices, JOHCM Global Opportunities (GB00BJ5JMC04) had just 30.1 per cent of its assets in the US at the end of June so looks well positioned to be a diversifier. Perhaps more importantly, the fund’s managers have a strong focus on protecting capital in difficult markets. Analysts at fund rating agency FundCalibre noted earlier this year that JOHCM Global Opportunities “has capital preservation at the heart of its investment process”. 

This fund is also concentrated, with only around 30 holdings, but managers Ben Leyland and Robert Lancastle deliberately screen out companies they think have the potential to make big losses. FundCalibre adds that they exclude companies with the biggest causes of capital destruction, such as weak franchises, high levels of debt and overvalued assets.

Both these funds have significant cash piles, meaning they could snap up bargains in volatile markets. However, they also have significant exposure to quality companies with defensive characteristics such as strong brands or balance sheets, which have been popular in recent years. This means they now have high valuations so look exposed to a change in sentiment.

If you want a fund that takes more of a contrarian approach options include River & Mercantile Global Recovery (GB00B9428D30). It has less than 20 per cent of its assets in the US and also invests according to a value approach. Its manager, Hugh Sergeant, backs out-of-favour companies that he believes will benefit from a recovery in profitability over the medium to longer term.

“The manager is willing to take large country deviations away from the benchmark in pursuit of the most attractive stocks that meet his investment philosophy and process," explains Mr Pereira. "This has resulted in the fund having below 20 per cent invested in the US. Its returns are therefore likely to differ from the benchmark in the short term, but we believe that the manager's well-defined process should work over the longer term.”

But this is still a high-risk option. Value investments have lagged the market and the fund has had a mixed track record. Some investors suspect that value investments will soon return to form, but this often relies on a rise in interest rates – something that looks unlikely in the near future.

Global income with lower US exposure

Mr Park points out that global equity income funds are more likely to have substantial exposure to Europe than the US, meaning that there are plenty of options with which income investors can diversify away from the US. Mr Pereira favours Janus Henderson Global Equity Income (GB0031263899), whose managers' focus on dividend-paying companies has led them away from the US. And while this has sacrificed some return relative to broad global indices, Mr Pereira argues that it is a defensive holding with a “solid income profile, both in terms of yield and dividend growth”. It has a 12-month yield of about 3.5 per cent.

Fidelity Global Dividend (GB00B7778087) has less than 30 per cent of its assets in the US, with 33 per cent in Europe and 20 per cent in the UK. The fund, managed by Daniel Roberts, has performed well in recent years despite a difficult 2017, but this strong performance may have limited the income it generates, given that yields move inversely to prices. The fund has a 12-month yield of 2.7 per cent. Analysts at The Adviser Centre note that the fund, which focuses on companies with predictable and consistent cash flows, displays defensive characteristics and should appeal to cautious investors with a focus on income.

A higher income is available from Fidelity Global Enhanced Income (GB00BD1NLJ41). This fund, co-managed by Mr Roberts and David Jehan, has a 12-month yield of 4.42 per cent and has performed well in recent years. 

A big difference between this and the other two equity income funds is that Fidelity Global Enhanced Income can write call options – contracts agreeing to give other investors the right to buy some of the stocks held by the fund at a specified price within a set period. The income it gets from doing this allows the fund to pay a higher income to its investors, but the call options also limit its performance when markets rise because they entitle other investors to buy certain of its holdings when they are performing well. However, this fund has performed well over the past five years.

This approach also reduces the fund’s exposure to the US, which was 29.3 per cent at the end of July, or 21.2 per cent when its options are accounted for.

Source: FE Analytics. Performance data as of 09.08.19

*Offshore share class used for longer track record