How investors can diversify their US equity exposure

Areas like small and mid-caps as well as value stocks started to outperform in late 2019 – but will these new trends last?

If equity investors have had a successful decade, much of this is down to the performance of the US market.

Many investors have long viewed US stocks as expensive, and lofty valuations only have further to fall if the economy runs into trouble

The S&P 500 has outperformed major indices in the UK, Europe, Asia, Japan and emerging markets over six of the last calendar years in sterling terms.

As of late December it led the pack over one, three, five and 10 years.

2019 has only seen a continuation of this trend: the country’s equity market has dominated its peers, with the S&P 500 making a sterling return of more than 20 per cent.

This index hit a fresh all-time high towards the end of 2019 as trade tensions between the US and China appeared to ease.

However, when combined with some of the challenges facing investors, such strong returns can pose a problem.

High valuations

Many investors have long viewed US stocks as expensive, and lofty valuations only have further to fall if the economy runs into trouble.

Among other challenges, the US/China trade war is expected to rumble on despite recent concessions and global growth looks far from robust.

At the same time, the FAANG stocks that have tended to lead both rises and falls in the market in recent years face problems of their own.

Meanwhile, 2019 has brought glimmers of hope for a different segment of the market.

In early September, for example, energy stocks in the S&P 500 sold off heavily while classic “value” names such as energy stocks made significant gains.

While global growth remains relatively anaemic for now, any move towards fiscal stimulus – an idea mooted by various developed market governments – could create conditions that tend to favour a value approach.

All of this means that while investors are reluctant to turn their backs on the world’s leading market, it might be time to at least fine-tune their exposure.

As noted, one idea to consider is the resurgence of value stocks.

In the November issue of its global fund manager survey, Bank of America Merrill Lynch observed that professional investors had made a big move into value stocks on the back of higher inflation expectations and reduced concerns about a coming recession.

And value has certainly stood out in the US lately.

The S&P Value index lags its Growth counterpart over the last, three five and 10 years, but the two are roughly level over one year.

Furthermore, the Value index was up by 13 per cent for the six months to 18 December in local currency terms, outpacing a 7.7 per cent gain in the Growth index.

As such, funds with exposure to classic value sectors such as financials and industrials might be worth considering.

As of 18 December, the best performer from the Investment Association’s North America sector over one year was Janus Henderson Opportunistic Alpha, a name with around 45 per cent of assets in financials, industrials and materials at the end of September.

That said, there are other considerations to bear in mind.

“Disruption is increasingly a harsh reality for many once‑dominant companies.

“But these days, some of these legacy companies have recognised how this is playing out and are fighting back aggressively.

“They are moving from the wrong side back to the right side of change,” says Taymour Tamaddon, portfolio manager, large cap growth equity strategy at T. Rowe Price US

Value investing

Value has also had several false dawns in a decade that has seen it severely underperform growth.

“Reversals of style regimes can be unpredictable but typically happen abruptly and can be sustained for a long time.

“We question how well positioned many investors are for such a change,” says Heather McPherson, portfolio manager of the T. Rowe Price US large cap value equity strategy.  

Value stocks famously surged in 2016, only for this rally to peter out the following year.

Many of the factors that have aided growth investors, from tech disruption to loose monetary policy, look difficult to shift.

As such, instead of looking for a dedicated value fund it may simply be worth looking for products with some exposure to those sectors, as well as assessing the positioning of funds you already hold.

Many funds with an agnostic approach or even a growth bias have tilted into value in the last year.

Small and mid-cap stocks remain a good source of returns: the Russell 3000, which contains some smaller names, has outperformed the S&P 500 over one, three, five and 10 years in sterling terms, as of 18 December.

And given that these companies tend to do well or badly depending on the state of the US economy, they could prosper if trade tensions continue to recede.

As such it is worth perusing either US smaller companies funds or even generalist funds that delve into areas like these.

When it comes to specialist US smaller companies funds, JPM US Small Cap Growth is one fund that has fared well in the short and long term.

In the generalist space, the Brown Advisory US Equity Growth fund, which is among the best performers of the last year, does hold large names such as Amazon, Visa and Microsoft but can also invest in medium-sized companies.

Other themes are equally important.

FAANG stocks

The FAANG stocks, for example, have not recently driven markets in the way they previously tended to.

They also face regulatory scrutiny – but still generate positive returns and make up a large part of many funds.

But it is worth noting the resurgence of older tech names: Microsoft, for example, has gone from the risk of seeming defunct to regaining its momentum.

As much as the US market has winners and losers, such trends are difficult to predict.

The value trade could prove a damp squib, small and mid caps could suffer if any economic downturn does arise, and the tech world faces various challenges. As such, any bias to these areas should be expressed within a broader portfolio.

Ben Yearsley, of Shore Financial, blends four funds that are predominantly US-focused: Polar Capital Global Technology, the Biotech Growth Trust, Legg Mason Royce US Smaller Companies and long/short offering Artemis US Extended Alpha.

He has gone for this approach to tap into the US economy via smaller companies but also access some of the country’s leading industries, tech and biotech.

As he notes, “you could do a lot worse than simply buying an S&P tracker”.

But investors with strong views on the US outlook could consider a more nuanced approach.