The Covid-19 pandemic might have ushered in huge changes to everyday life but it has done nothing to undermine the most persistent market narratives of recent years. Growth stocks continue to storm ahead, unloved markets such as the UK still lag other regions, and returns from the world’s leading equity market are dominated by just a handful of stocks.
US equities have been the winning play of 2020, but much of this success stems from the phenomenal gains made by the biggest tech shares. The so-called FAANG stocks have led the charge in the huge equity rally that began in April.
With these companies tightening their grip on a variety of different markets, the FAANGs, tech and growth stocks more generally could continue to lead the way. But as the chart shows, they now make up a huge part of the S&P 500 and funds that track it. The FAANGs made up around 17 per cent of the iShares Core S&P 500 UCITS ETF (CSP1) in mid-September. This figure climbs to nearly 23 per cent when Microsoft (US:MSFT) is included.
Many active funds will also have large exposures, even if this is just to stay broadly in line with a highly concentrated market that is notoriously hard to beat. Baillie Gifford American (GB0006061963), one of the most successful US funds, included just three of the FAANGs in its top 10 holdings at the end of August, yet they still represented 15.6 per cent of assets.
As we note, the FAANGs, Microsoft and other growth stocks could continue to lead the way as investors look for certainty amid the pandemic, and attempting to go entirely against this trend could have dire consequences for your portfolio. But with markets riding high on the back of just a few stocks, diversification is increasingly important.
Taking exposure to a spread of asset classes, geographies and sectors continues to look wise, but investors may also want to consider those funds succeeding in concentrated markets without leaning too heavily on the leading stocks. This applies not just in the US but in markets like Asia where index concentration has also taken hold.
Growth with less FAANG reliance
Some funds have managed to generate strong returns without relying on the tech giants by looking further down the market cap scale, and LF Miton US Opportunities (GB00B6Z0P562) is a good example. The fund, which entered the IC Top 100 Funds list this year, picks stocks from within the Russell 3000 index, giving it a greater focus on the likes of mid-cap shares. Managers Nick Ford and Hugh Grieves take a strict bottom-up approach, seeking companies with the best opportunities within their industry or sector. The team favours companies with highly recurring revenues or frequent small purchases by customers, a limited need for finances to support business growth, and those that operate in areas with high barriers to entry.
Its biggest holdings at the end of August included Fidelity National Information Services (US:FIS), a provider of banking software, Waste Connections (US:WCN) and HCA Healthcare (US:HCA).
The fund is relatively concentrated with just 42 holdings at the end of August, but does provide a source of growth with less dependence on the tech majors. Importantly, it has not sacrificed performance by looking past the FAANGs, outpacing the S&P 500 over one, three and five years. Those with a tolerance for the heightened risks of small-cap investing may also note that the same team runs another strong performer, LF Miton US Smaller Companies (GB00BF54HB10). It only launched in 2018, but has held up well so far.
Large-cap US funds have more of an obligation to hold the big tech stocks, and finding one without any exposure is unlikely. But some managers have managed to outperform without leaning too heavily on these names.
Darius McDermott, managing director at fund research business FundCalibre, notes that Legg Mason Martin Currie US Unconstrained (GB00BVZ6VD94) has done well without too much FAANG exposure. The fund’s recent positions in Amazon (US:AMZN) and Microsoft were roughly in line with their market weightings, catapulting them into its top 10 holdings. But its biggest positions also include consumer plays such as Nike (U:NKE), and medical technology business Masimo Corporation (US:MASI). It is important to note that the fund does still have a big focus on tech – information technology made up nearly 40 per cent of assets at the end of August. This is also a highly concentrated portfolio, with just 22 holdings.
Income funds, whose hunt for yield can sometimes steer them past growth plays, can also offer some differentiation. Adrian Lowcock, head of personal investing for Willis Owen, suggests JPM US Equity Income (GB00B3FJQ599), a fund that is overweight financials and underweight technology.
"The portfolio has a broader exposure to the US economy through the focus on strong durable franchises which can offer stable income growth," he says.
Concentration issues in Asia
As noted, the US is not the only market led by the performance of a few big names. Asia is a region that holds great promise for investors, but both active and passive funds are often hostage to the fortunes of Alibaba (US:BABA), Tencent (HKG:700), Taiwan Semiconductor Manufacturing (US:TSM) and Samsung Electronics (SMSD). Like the FAANGs, these stocks have delivered big returns in recent years but now make up a big chunk of their market (see chart).
Again, finding funds with no exposure might prove tricky, but some managers have found growth opportunities beyond the market’s biggest stocks.
Mr McDermott notes that Fidelity Asia Pacific Opportunities (GB00BMZN2Q75) has held up well in recent years. The fund did list Taiwan Semiconductor Manufacturing Company as one of its top 10 positions at the end of August but had no money allocated to Alibaba, Tencent or Samsung. Manager Anthony Srom uses a bottom-up approach to pick stocks based on investor sentiment, valuation and fundamental research. His approach is described as “broadly style neutral”, but new positions in the portfolio can exhibit something of a contrarian bent. The fund is highly concentrated, with just 29 holdings at the end of August.
Another fund with less of a focus on the biggest market constituents is Stewart Investors Asia Pacific Leaders (IE00BKDRZ794). The fund’s managers focus on large and mid-cap companies, with consideration given to businesses that can benefit from, or contribute to, the sustainable development of the countries in which they operate.
As with the Fidelity fund, this name did list Taiwan Semiconductor Manufacturing Company among its top 10 holdings but the other big names were notably absent. Major holdings include Tata Consultancy (US:TCS) and Unicharm Corporation (JAP: 8113), a Japanese provider of disposable hygiene products.
Investors may note that this fund has underperformed its benchmark, MSCI AC Asia Pacific ex Japan Index, over one and five years to 31 August, possibly because of the regions it has favoured. The fund had just 7.1 per cent allocated to China at the end of August – a market that makes up some 40 per cent of the index and has performed strongly in the recent past. Avoiding China is generally very difficult in active Asia and emerging market funds, though some passives do have limited exposure. A few products, such as the Lyxor MSCI Emerging Markets ex China UCITS ETF (US:EMXC) explicitly avoid the region.
The Stewart Investors fund also has a big allocation to India, a market that has struggled in recent years. As with any contrarian or diversifying position, there is a risk that recent performance trends persist and this fund continues to lag behind.
Going global
We suggested in the Big Theme of 16 August 2019 that investors could diversify away from the big tech names by holding global equity funds with limited exposure to the US, which makes up a big chunk of the MSCI World index. This argument still holds up, though investors do need to remember that this contrarian approach may not pay off. That risk is illustrated by how the funds we highlighted last year have fared in a time when investors have once more piled into the US tech majors and shunned many other companies and markets. Value fund River and Mercantile Global Recovery (GB00B96FYM16) has struggled, losing nearly 8 per cent in the year to 17 September. Investors may again be tempted to diversify via some value exposure, but this could be extremely risky amid the pandemic. Investors have generally favoured quality names which appear to offer some security, and determining the catalyst for a value comeback is not easy.
“Sometimes value outperforms just because it’s too cheap,” Mr McDermott notes. But he adds that growth investing should be the best place to be in a time of 'low interest rates and inflation, while the effects of Covid-19 continue to ravage economies.
A more quality-minded US-light approach is available via Lindsell Train Global Equity (IE00B644PG05), which had just 32 per cent of assets in the US at the end of July and focuses on buying and holding companies with strong, durable brands.
Investors could also, instead, diversify at the margin. Last year we highlighted Sanlam Global High Quality (IE00BYV7PR98) as a fund that has exposure to both the FAANGs and the US, but less of a weighting to the latter than many of its peers. This is still the case, and the fund has delivered a positive return this year, though still lags MSCI World.
With global funds it is also wise to avoid too much duplication between their holdings and exposures, and those elsewhere in your portfolio.
