Between speculation over a Fed rate rise, two upcoming elections, and a technical recession, volatility could be ahead for North America, says Julia Faurschou
UK investors looking to diversify often look across the pond as North American funds offer a sense of familiarity while adding a new geographic region to a portfolio. While both are developed nations, the respective continents are impacted by economic factors in different ways.
Economic commentators continue to speculate whether the US or the UK will be the first to raise interest rates, although lately most have pointed to the Federal Reserve (Fed). However, both the International Monetary Fund (IMF) and the World Bank have warned against a US rate rise in the near future, preferring the Fed to wait until the world economy is in a more stable condition. Both these institutions were set up at Bretton Woods to advise on global economic stability. The institutions believe that a rate rise now would disrupt global economic instability further, and could be catastrophic for emerging markets, potentially leading to a crisis situation.
Although most people initially think of the United States when they think about North American funds, Canada also comprises a significant portion of the sector. The economies of the two countries differ greatly at the moment – while the US boasts an economic recovery and a potential interest rate hike, Canada recently entered a technical recession and lowered its base rate, largely due to continued low oil prices.
Political uncertainty often results in increased volatility in markets – and both the US and Canada have imminent elections. Canada’s, set for 19 October, will see the ruling Conservative party challenged by its old rival Liberal Party, as well as the up-and-coming New Democratic Party. The US election, set for 2016, could see old rivalries between the Bush and Clinton families come to a head, and the potential nomination of outspoken entrepreneur Donald Trump will entertain voters in the meantime.
Fund facts
To qualify for the North America sector, a fund must invest at least 80 per cent of its assets in North American equities. Similarly, to be included in the North American Smaller Companies sector the fund must invest at least 80 per cent of its assets in North American equities of companies which form the bottom 20 per cent by market capitalisation.
Investors should note the difference between the definition of “small cap” in the US versus the UK because as the saying goes, everything is bigger in America. The US market restricts small-cap companies to a valuation of between USD $300m and $2bn (£195m and £1.3bn), compared to the UK definition as between £15m and £349m. Under American standards, many FTSE 100 companies would be deemed small caps.
Smaller companies are often perceived to have greater investment risk than their larger counterparts. When comparing individual companies this can often appear to be the case, but when risk is spread across a diversified portfolio of shares the risk between the two sectors becomes more stable.
Risks that investors should bear in mind when considering smaller companies include their room for potential gains and losses. These companies are often less established than big companies, but their room to grow can result in large returns for investors who get in early.
On the other hand, companies in their early days face the challenge of finding their place in a given market, and some will naturally fail. Larger companies, although more set in their place in the market, also have less room for expansion or growth. However, shares in large companies are often more liquid than those in smaller businesses, especially those that are household names.
For the sake of comparison, both the North America and North American Smaller Companies sectors are combined in the data in Table 1. The top 10 unit trusts are dominated by the North America sector, with a slightly more even distribution in the top nine investment trusts (as there are only that many trusts across the two sectors).
The best performing unit trust was the Legg Mason Opportunity, managed by Samantha McLemore since its launch in 2009. The fund invests primarily in US equities, with its largest holdings in healthcare data company Intrexon Corporation, Delta Airlines, and homebuilder Lennar Corporation. Broken down by sector, the fund focuses most on consumer discretionary at 30.2 per cent, financials at 18.3 per cent, and information technology at 18.1 per cent.
The second best performing unit trust was the New Capital US Growth fund, which invests almost entirely in American equities with a focus on both non-cyclical and cyclical consumer goods, communications, and technology companies. The top holdings list reads like an all-star roundup of some of the most well known American companies, including Apple, Facebook, Google, Nike and Starbucks.
The top performing smaller companies-focused unit trust is the Janus US Venture I Inc fund, which focuses mainly on American information technology, healthcare, industrials, and consumer cyclicals. Its top holdings are in financial services technology company SS&C Technology Holdings Inc, manufacturing company Sensient Technologies Corporation, and electronic design company Cadence Design Systems Inc.
Harwood’s North American Smaller Companies investment trust was the best performer across the two sectors. The trust invests 96.9 per cent in North American equities and is managed by Christopher Mills.
While speculation around interest rates is set to continue, and volatility may well increase as the continent gets closer to two separate elections, the North America and North American Smaller Companies sectors offer UK investors a good way to diversify without straying too far into the unknown.
Five questions to ask
1. Should I recommend a North America fund or a North American Smaller Companies fund?
That depends on the client. Larger companies tend to be more stable as they are often established in their market. However, smaller companies have more room to grow.
2. Are smaller companies more volatile?
Not necessarily, especially if you diversify. Although, by their nature, smaller companies will usually have a large capacity for gains or losses. Small companies are not necessarily young businesses – some smaller companies may be well established, but are simply smaller firms.
3. Is it really diversification if it’s another developed nation?
Yes – it is a different continent and a different market, so will react in different ways to economic indicators than the UK economy. The fact it is a developed market may make it a less risky asset to diversify into than an emerging market, but it is different nonetheless.
4. How do I deal with the exchange rate?
The exchange rates between the pound, US dollar, and Canadian dollar are bound to fluctuate. However, UK investors can purchase North American-focused funds that are denominated in sterling so that they do not actively have to check when is a good time to buy or sell shares based on the exchange rate. Currency-hedged ETFs are also a good way to defend against exchange rate risk.
5. Are North American funds more expensive than UK funds?
Perhaps, but it all depends on the fund and the focus of the investment. Some funds have a USD- and a GBP-denominated version of a fund, so it can be worth looking at exchange rates to see if they make one fund significantly cheaper to buy. However, this could be much different when it comes time to sell. Also, shares in smaller companies tend to be cheaper than those in larger companies, but are usually less liquid.
