Take a proactive approach to your US fund selection

Active US equity funds, on average, struggled to beat the S&P 500 index for a number of years meaning that many investors have favoured passive US equity funds, at least for exposure to larger, mainstream companies. And with US equities generally moving in an upwards direction for many years this has been a profitable way to get exposure to them at a low cost. 

However, if and when US markets go in the other direction passive funds will feel the full effect of the falls, whereas active US equity funds with a selective set of holdings might not be hit as badly. Because of US equities’ good run and markets continuing to hit new highs there have been concerns that a correction is due. Although while US equity funds, on average, had failed to outperform the S&P 500, individual active funds have succeeded in doing this. And, more recently, active US equity funds, on average have been doing well, even as markets keep rising. For example, over one, three, five and 10 years to the end of August, the Investment Association (IA) North America fund sector average is ahead of the S&P 500 index in sterling total return terms.

However, analysts and advisers argue that active funds may still find it difficult to outperform this index over the long term. “The pandemic caused a lot of change with big winners and losers which seemed to really favour active managers who have outperformed around the world in the past 18 months,” says Darius McDermot, managing director at Chelsea Financial Services and research company FundCalibre. “It will be hard [for US equity funds] as a group to outperform over the long term unless something big happens to upset the big US tech names. The US is a very large, liquid and well-informed market [and] US megacaps are great businesses. As an active manager, it’s been very hard to beat an Apple (US:AAPL), Microsoft (US:MSFT), Amazon.com (US:AMZN) or Alphabet (US:GOOGL) over the past 10 years. And they are such a large part of the index that they are hard to overweight.”

Ryan Hughes, head of investment research at broker AJ Bell, points out that “the constituents of [fund] sectors are relatively fluid so one has to be careful not to read too much into the statistics behind them. The IA North America sector now [includes] a large number of growth-focused funds which have performed well over time. And, at the same time, weaker-performing funds get merged away or closed which can distort the true picture. This survivorship bias can paint a very different picture of how the average active manager is performing over time.”

And active US funds will not necessarily be spared from market falls, when they happen, or fall less. “It’s a bit of a myth that active equity funds will somehow save you if the market falls,” says McDermott. “Very occasionally a manager might do something very clever and short their portfolio before the market crashes or avoid an entire sector that later suffers. But in 99.9 per cent of cases funds will fall with the market. Some funds will give a bit more protection but in a true crisis everything falls.”

That said, some active funds can outperform so rather than look at averages it is better to assess each fund individually.

“Apple, Microsoft, Amazon, Facebook (US:FB) and Alphabet make up [around] 23 per cent of the S&P 500 so their performance will strongly influence the performance of the index,” says Hughes. “With the market riding high and some of these stocks on stretched valuations, they may well be vulnerable to a reduction in market confidence or signs that the economic recovery is weaker than expected. This may suit active managers who are underweight these key stocks in the market. If we see a market fall led by the growth sectors I’d expect active managers who invest in other parts of the market to outperform. However, a Covid-led fall that once again supports technology companies due to there being another lockdown would mean that the average active manager is likely to underperform the index.”

A bit of both

A good approach can be to get exposure to US equities via both active and passive funds. “With larger companies being very efficient and hard to outperform, using a passive manager to gain low-cost exposure to the S&P 500 alongside an active manager who invests in medium and smaller companies can provide a nicely diversified portfolio that isn’t too expensive,” says Hughes. “Equally, you may want to combine a passive core alongside some specialist active managers to give specific exposures to certain sectors such as technology or healthcare, for example. It can be useful to think of how passive [funds] can work [alongside] active managers, rather than simply looking at whether it should be one or the other.”

For passive exposure to US equities, McDermott suggests Fidelity Index US (GB00BJS8SH10) because “it’s a cheap, solid fund and it’s hard to go far wrong with this for long-term exposure”.

This fund has an ongoing charge of 0.06 per cent and tracks the S&P 500 index. It does not necessarily invest in all the companies in this index for reasons including reducing dealing costs. It may get exposure to S&P 500 companies via derivatives such as exchange traded index futures. For example, at the end of July, its 10 largest holdings included E-mini S&P 500 Future Sept 21 as well large well-known S&P 500 constituents such as Apple, Microsoft and Amazon.com.

Hughes suggests iShares Core S&P 500 UCITS ETF (CSP1). “This gives exposure to the index for just 0.07 per cent a year making it a very cost-effective method of accessing the largest companies in the world,” he says.

This fund tracks the S&P 500 by buying companies included in this index rather than using derivatives. It had assets of $52.81bn (£38.69bn) at the end of August so is large and liquid.

Also see the IC Top 50 ETFs for more suggestions on passive funds for US equity exposure.

Active funds for US exposure

While some active funds have a good record of beating the S&P 500 it is unlikely that they will outperform over every time period, especially as many of these have an investment style bias.

“Anyone using an active [fund] has to accept that there will be periods of underperformance,” says Hughes. “So it’s vital to understand how it invests and when it is likely to do well or badly as this will hopefully stop you buying at the top and selling at the bottom. If you are not comfortable with this, or haven’t got the time to spend researching and monitoring active managers, a passive fund will work very well, giving broad market exposure.”

In any case, if you invest in equities – in particular overseas listed ones – you should have a long-term investment horizon and be able to sit through periods of volatility and underperformance.

McDermott suggests Baillie Gifford American (GB0006061963) for taking advantage of growth trends. “This is a heavily stylistic fund geared towards growth [and] has delivered excellent performance,” he says. “If you are going to go active in the US there’s no point getting a closet tracker – you want something [that] can really beat the index when it delivers. But the fund will struggle if growth-style [investing] goes out of favour.”

The fund aims to outperform the S&P 500 Index, as stated in sterling, by at least 1.5 per cent a year over rolling five-year periods after deduction of costs. Its management team invests with a five to 10-year view so that the advantages of its holdings' business models and cultural strengths have long enough to become the dominant drivers of their stock prices. They target businesses that they think are innovative, disruptive and run differently to the average company.

Baillie Gifford American’s largest holdings at the end of July were Shopify (CAN:SHOP), a cloud-based commerce platform for small and medium-sized businesses, coronavirus vaccine company Moderna (US:MRNA) and Trade Desk (US:TTD), an online advertising platform. The fund’s 10 largest holdings also included some of the largest companies in the S&P 500, such as Amazon.com and Tesla (US:TSLA).

At the end of July, the fund's 10 largest holdings accounted for nearly half of its assets so it is fairly concentrated. While this can boost performance if these do well, if any of these holdings' share price falls it would have a bigger effect on the fund’s overall return than that of one that is more diversified.

Baillie Gifford American has a very reasonable ongoing charge for an active fund of 0.51 per cent.

Hughes also highlights Baillie Gifford US Growth Trust (USA), which is run by two of the same managers as Baillie Gifford American Fund – Gary Robinson and Kirsty Gibson. The investment trust has a similar asset allocation and many of the same largest holdings as the fund, but can also invest up to 50 per cent of its assets in unquoted companies. At the end of July, it held 21 of these which accounted for 16.4 per cent of its assets. This increases the potential for outperformance but also risk.

The trust has an ongoing charge of 0.68 per cent, but this could fall. It recently lowered its annual management fee from 0.7 per cent on its first £100m of net assets and 0.55 per cent on those above that value, to 0.7 per cent on the first £100m of net assets, 0.55 per cent on the next £900m and 0.5 per cent on those in excess of £1bn. Baillie Gifford US Growth Trust had total assets of just over £1bn at the end of July.

Artemis US Select (GB00BMMV5105) also has a good record of beating the S&P 500 index. Its manager, Cormac Weldon, has a long record of outperforming this index and has invested through many market cycles. Weldon and his team pay attention to evaluating potential financial, market and economic risks as well as investment opportunities. They invest in stocks where they think the potential upside greatly outweighs downside risk. They also change their focus as the economic and market cycle changes.

Examples of holdings at the end of August included Alphabet, Microsoft and transportation company Norfolk Southern (US:NSC).

If you invest in a passive US fund, you may get over exposure to the same stocks if you hold this fund or the Baillie Gifford funds as well. But Weldon and his team also run Artemis US Smaller Companies (GB00BMMV5766), which typically holds 50 to 70 stocks with a market value below $10bn. They aim to have a select list of companies while holding enough to mitigate the higher levels of volatility smaller companies experience, via diversification. As part of its investment analysis, the fund’s investment team analyses economic trends to understand cyclical and long-term trends, and the outlook. The fund has a good record of beating the Russell 2000 index of smaller companies.

It provides very different exposure to US equity funds focused on larger companies with, for example, only 8.7 per cent of its assets in technology companies at the end of August. Industrials accounted for nearly a third of its assets and financials about a fifth. Its largest holdings were broker-dealer LPL Financial (US:LPLA) and Bio-Techne (US:TECH) which produces reagents and instruments for research and clinical diagnostics markets.

Schroder US Mid Cap (GB00B7LDLV43) “targets the middle part of the market and the heart of America, as manager Bob Kaynor describes it”, says McDermott. “He thinks that this part of the market is placed to do well as the US economy comes out of Covid. To diversify the portfolio, [he and his] team have three sources of stock returns. [These are] ‘steady eddies’ or less cyclically sensitive stocks [for] ballast; mispriced growth stocks where [they] feel that the market has not fully understood the company's earnings potential and – the smallest bucket – recovery-type situations. A strict sell discipline is in place with the setting of price targets.”

The fund’s largest holdings at the end of August included risk management company Assurant (US:AIZ) and biotechnology company Catalent (US:CTLT).

For more of a value and income tilt, Hughes suggests JPM US Equity Income (GB00B3FJQ599). It targets a dividend yield above that of the S&P 500 index, net of 15 per cent withholding tax, over a market cycle. The fund's management team favours companies with durable business models, consistent earnings, strong cash flows and experienced management teams. And they like companies to have what they consider to be attractive valutions.

The fund’s largest holdings and sector allocation are very different to those of the S&P 500 and many other funds focused on larger US companies. For example, at the end of August, information technology only accounted for 9.5 per cent of JPM US Equity Income's assets, but financials and healthcare accounted for 25 per cent and 16 per cent, respectively.

Its largest holdings included UnitedHealth (US:UNH) and Bank of America (US:BAC).