- Volatile markets mean that funds which track mainstream US equities might not continue to do as well
- They could still be a good way to get large-cap exposure over the long term
- You could diversify your US exposure with value style investing, income and smaller companies funds
The large, liquid nature of the US stock market, where companies are traded around the clock and heavily researched by broking analysts, means active US equity funds face a particular struggle to beat their benchmarks over the long term.
More recently, the rise of the technology sector and considerable growth of companies such as Amazon.com (US:AMZN), Microsoft (US:MSFT) and Apple (US:AAPL) has handed these businesses large weightings in indices like the S&P 500 – weightings that active managers struggle to match.
As a result, US equity tracker funds have outperformed active equivalents, also helped by lower charges that eat less into their returns. However, this year markets have become much more volatile with Russia’s invasion of Ukraine, concerns on rising inflation, and central bank monetary tightening among the principle causes.
The S&P 500 index, for example, fell 3 per cent in the week of 16-20 May, including 4 per cent on Wednesday 18 May – its biggest daily fall since June 2020. US equities have been on a downward trend since the start of the year, with the S&P 500 index falling 17.7 per cent – one of the steepest falls among all major markets.
"While a tracker fund remains a sound long-term buy-and-hold approach, in the near term S&P 500 trackers could continue to have a rocky ride as they are going to remain very vulnerable to an ongoing derating of growth stocks in sectors like tech and communication services, given the aggressive pace of monetary tightening," says Jason Hollands, managing director at Bestinvest. Indeed, outflows from exchange traded funds (ETFs) are a factor driving the sell-off."
Although there are still reasons why large US technology companies can continue to do well, Rob Morgan, chief analyst at Charles Stanley, says to consider whether you are comfortable with the share of US large cap-indices and tracker funds of which they account. For example, Apple and Microsoft, the two largest constituents in the S&P 500 index, comprise about 13 per cent of it – more than many entire sectors including energy, real estate, utilities and materials. The information technology, healthcare and consumer discretionary sectors accounted for 27.4 per cent, 14.2 per cent and 11.5 per cent of the S&P 500 index, respectively, at the end of April.
So if such large index constituents don’t perform as well, active funds could do better.
"Active funds often run a flatter portfolio so their performance can be more aligned with equal weight rather than market weight indices," adds Morgan.
Hollands says that funds which invest via a value investment approach – buy stocks that appear to be trading for less than their true value – could be a way to take a more defensive stance over the near to medium term. For example, in the week of 16-20 May, US growth stocks underperformed US value stocks by over 2 per cent, and have lagged them by around 17 per cent since the start of 2022. The active funds which have performed best over the past six months, accordingly, have tended to include a valuation discipline in their investment approaches.
|Top performing IA North America sector funds over six months|
|Fund||6-month total return (%)|
|Invesco S&P 500 High Dividend Low Volatility UCITS ETF||15.6|
|iShares S&P 500 Utilities Sector UCITS ETF||14.9|
|Fidelity American Special Situations||8.8|
|GQG Partners US Equity||7.7|
|BNY Mellon US Equity Income||6.8|
|Quilter Investors US Equity Income||6.8|
|BlackRock US Opportunities||4.7|
|SPDR S&P 500 Low Volatility UCITS ETF||4.4|
|Shares S&P 500 Consumer Staples UCITS ETF||4.3|
|SPDR S&P US Dividend Aristocrats UCITS ETF||3.9|
|Xtrackers MSCI North America High Dividend Yield UCITS ETF||3.3|
|M&G North American Value||3.2|
|US Equity Income UCITS ETF||3.1|
|iShares MSCI USA Quality Dividend UCITS ETF||2.9|
|BlackRock GF US Basic Value||2.9|
|Source: Trustnet, 24.05.22|
“Value funds produced good results, as did income strategies,” says Morgan. “This was partly down to exposure to energy and commodities, and a lack of exposure to troubled areas such as technology and healthcare. Looking ahead, we expect quite a divergence in terms of the ‘haves’ and ‘have nots’, but overall [the economic environment] favours quality business of all flavours – growth or value. This implies that many of the recent winners could continue to fare reasonably well, but also some of the broader-based funds which emphasise quality.”
So it could be a good idea to diversify your exposure across different areas and investment styles, rather than just focus on growth orientated funds. “Within the past six months especially we have seen a reminder that old fashioned concepts like dividends and valuation discipline should always have a place in portfolios, alongside exposures that are more growth orientated,” adds Morgan. “If you are buying active funds, a balance between growth, and value and or equity income type strategies is worthwhile.”
Funds which invest via a value approach include the actively managed Dodge & Cox Worldwide US Stock fund (IE00B50M4X14). Its managers look to invest in medium-to-large, well-established companies that they think are temporarily undervalued by the stock market but have a favourable long-term growth outlook. They also assess companies on the basis of their financial strength, economic condition, competitive advantages, business franchises, environmental, social, and governance (ESG) standards, and competence of their managements.
The fund was overweight financials and healthcare stocks, and underweight technology stocks, relative to the S&P 500 index, at the end of March. Its largest holdings included Charles Schwab (US:SCHW) and Wells Fargo (US:WFC). It has an ongoing charge of 0.63 per cent.
Fidelity American Specialist Situations (GB00B89ST706) takes a value and contrarian approach. Its “managers buy companies that have gone through a recent period of underperformance, are unloved and out of favour with little value ascribed to potential, but are fundamentally sound”, explains Morgan. “It has shown notable outperformance recently, although prior to that it understandably had an extended period in the wilderness.”
The fund has an ongoing charge of 0.86 per cent.
Passive factor funds such as the SPDR S&P US Dividend Aristocrats UCITS ETF (USDV) track more value orientated stocks than S&P 500 trackers. It tracks S&P Composite 1500 Index stocks which have increased their dividends every year for at least 20 consecutive years. The ETF has an ongoing charge of 0.35 per cent.
The Invesco FTSE RAFI US 1000 UCITS ETF (PSRF) tracks the FTSE RAFI US 1000 Index. Its constituents' weightings are set according to sales and cash flow averaged over the prior five years, book value, and total dividend distributions averaged over the past five years – rather than market caps. It has an ongoing charge of 0.39 per cent.
Alternatively, Artemis US Extended Alpha (GB00BMMV5G59) could help to mitigate market falls because as well as investing in stocks it takes short positions in certain shares.
Its managers, William Warren and Chris Kent, determine which companies to invest and take short positions in by analysing wider economic trends to understand cyclical and long-term trends, and the outlook.
The fund has an ongoing charge of 0.89 per cent, but can also charge a performance fee of 20 per cent of its outperformance against the S&P 500 index.
Despite the potential for volatility, Morgan argues that for US large cap exposure "a low-cost tracker is a really good option in a market where active investors struggle to find an edge, perhaps unsurprisingly given the huge attention and scrutiny surrounding the big constituents of the market."
Short-term volatility is also not a problem if you have a long-term investment horizon, which you should have if you invest in risk assets such as US equities. Passive funds focused on this market include the iShares Core S&P 500 UCITS ETF (CSP1) which is large and liquid with assets of £46bn, and the Vanguard S&P 500 UCITS ETF (VUAG) with assets of £28.5bn. Both funds have low ongoing charges of 0.07 per cent.
If you have a long-term investment horizon, high risk appetite and are happy to tolerate short-term volatility, you could hold an S&P 500 tracker fund alongside an active fund which invests in US smaller companies. “While there are index funds available that track US smaller companies, for example, the Xtrackers Russell 2000 UCITS ETF (XRSG), active managers have a better record of adding value in this part of the market,” says Hollands. “About 60 per cent of funds in the Investment Association (IA) North America Smaller Companies sector have beaten the Russell 2000 index over the past 10 years.”
Morgan also favours active funds for smaller companies “because the market is so diverse and specialist research is more likely to yield results from exploiting opportunities fewer other participants have seen”.
Hollands suggests Artemis US Smaller Companies (GB00BMMV5766), run by experienced manager Cormac Weldon. He holds 50 to 70 smaller companies across various sectors including industrials, consumer discretionary and healthcare. The fund’s largest holdings at the end of April included Clean Harbors (US:CLH), Ovintiv (US:OVV) and LPL Financial (US:LPLA).
The fund has an ongoing charge of 0.87 per cent.
Hollands also highlights Federated Hermes US SMID Equity (IE00B8JBCY79) which invests in small- and medium-sized companies. Its managers select companies they consider to be high quality, attractively priced, and meet a number of ESG standards. They also like companies to have a durable competitive advantage, and sustainable and stable earnings. Its top holdings at the end of April included Chart Industries (US:GTLS), Gartner (US:IT) and AMN Healthcare Services (US:AMN).
Its ongoing charge is 0.84 per cent.
Brown Advisory US Smaller Companies (IE00B0PVDH59) looks to invest in companies which can reinvest their earnings and grow organically. “It aims to sieve out [smaller companies] with a style best described as quality growth,” explains Morgan. “Its benchmark – the Russell 2000 index – is home to many speculative growth companies, many of which are unprofitable. Avoiding these areas means the fund tends to capture less market upside, but in more stressed market conditions the resilience of its business comes to the fore and it typically adds value.”
It has an ongoing charge of 0.86 per cent.
Brown Advisory US Smaller Companies Fund’s managers, Christopher Berrier and George Sakellaris, also run the Brown Advisory US Smaller Companies (BASC) investment trust which uses the same investment strategy.
If you do not want the potential risk and volatility of a dedicated smaller companies fund, Premier Miton US Opportunities (GB00B8278F56) could also help to diversify mega-cap growth concentration in the S&P 500 index. It takes “a pragmatic approach to seeking out the best opportunities”, explains Morgan. “The fund can access ideas from across the size spectrum and is well spread across a variety of different industries."
The fund has an ongoing charge of 0.85 per cent.
|Fund performance – cumulative total returns|
|Fund/benchmark||6mth (%)||1yr (%)||3yr (%)||5yr (%)||10yr (%)|
|Artemis US Extended Alpha||-10.08||5.47||41.13||78.55|
|Dodge & Cox US Stock||-2.23||8.15||44.16||68.49||343.77|
|Fidelity American Special Situations||8.84||17.86||38.74||55.58||303.35|
|Invesco FTSE RAFI US 1000 UCITS ETF||0.05||12.48||49.75||73.99||320.89|
|iShares Core S&P 500 UCITS ETF||-9.01||8.61||47.91||84.60||347.22|
|SPDR S&P U.S. Dividend Aristocrats UCITS ETF||4.90||13.69||36.30||66.75||290.36|
|Vanguard S&P 500 UCITS ETF||-9.19||8.34||47.60|
|S&P 500 index||-9.92||7.69||41.88||71.05||276.61|
|Premier Miton US Opportunities||-7.38||2.33||46.05||83.83|
|Russell 3000 index||-12.09||4.41||42.85||75.70||315.69|
|IA North America sector average||-12.44||2.91||37.91||69.44||274.28|
|Artemis US Smaller Companies||-22.67||-12.00||27.85||71.74|
|Brown Advisory US Smaller Companies Fund**||-15.52||-7.39||23.61||65.64||290.58|
|Federated Hermes US SMID Equity||-14.24||-1.79||21.26||40.49|
|Brown Advisory US Smaller Companies investment trust share price||-21.23||-14.34||9.52||47.67||159.59|
|Xtrackers Russell 2000 UCITS ETF||-17.29||-8.46||22.46||39.52|
|IA North American Smaller Companies sector average||-19.42||-8.84||26.46||54.03||246.39|
|Russell 2000 index||-17.96||-8.36||23.23||39.88||221.20|
|Source: FE Analytics, 23 May 2022.|
|**The history of this unit/share class has been extended, at FE fundinfo's discretion, to give a sense of a longer track record of the fund as a whole.|
Avoid over exposure
US equities represented around 68 per cent of MSCI World index at the end of April, and the US economy is the world’s largest by gross domestic product, so it is not a market growth investors can ignore. However, Hollands argues that UK-based investors should not have such a large weighting for reasons of diversification and foreign exchange risk. “Your portfolio’s level of US equity exposure depends on its risk profile and objectives, but could range from 15 per cent to 30 per cent,” he suggests.
When you have decided how much US equity exposure is suitable for your investment objectives and profile, before adding any dedicated US equities funds first consider how much exposure to this area your portfolio already has. Look to see what US equity exposure is found in your global equities funds – especially passive ones. By the same token, many active global equities funds also have over half their assets in this area. For example, Fundsmith Equity (GB00B41YBW71) had 73.8 per cent of its assets in US equities at the end of April.
But not all exposures will be of the same type. And global equity income funds often have less US exposure as this isn’t a higher-yielding market and funds which take a value style investment approach might have different allocations.
Technology and healthcare funds, meanwhile, tend to have around three-quarters or more of their assets in US equities because this is where many of these types of companies are listed. If you have US exposure via global equities and dedicated US equity funds, look carefully at their exposures and holdings before adding a technology or healthcare fund to avoid being over exposed to certain stocks.