How to build a diversified actively managed US equity portfolio

Applying diversification to the US market can be tricky. A diversified US equity portfolio will include a wide range of sectors. But a small clutch of sectors dominate the economy and stock markets.

Alec Murray, head of equity client portfolio managers at Amundi US, says: “By far the most dominant sector in US large-cap core equities is technology. The consumer sector is also a large sector within the US markets, while financials, health care and industrials are also prominent.”

In recent years, this has created problems for those seeking to invest in a diversified way in the main US markets.

We try and minimise this volatility by operating ‘blend’ portfolios, picking the very best growth and value ideas from across the spectrum.Andrew Smith, Columbia Threadneedle

Ayesha Akbar, portfolio manager at Fidelity International, says: “The composition of the S&P 500 has changed considerably, given the growth of a handful of technology stocks,” creating a “lack of breadth”.

This in turn has driven interest in small-cap indices like the Russell 2000, she adds, “which tend to have a more diversified range of sectors represented”.

Portfolio composition

Columbia Threadneedle’s view is the best way to build a diversified US portfolio, with predictable and consistent returns, is through being relatively sector and factor neutral.

Andrew Smith, client portfolio manager for US equities at Columbia Threadneedle, explains: “Given the past few years have been characterised by often sharp factor rotations and changes in style leadership in the market, we try and minimise this volatility by operating ‘blend’ portfolios, picking the very best growth and value ideas from across the spectrum.”

You not only need to know where their sales occur, but what their cost base looks like as well.Eric Papesh, T Rowe Price

The aim, he adds, is to generate steady positive performance from bottom-up stock selection, “rather than from camping out in a particular style like growth or value where we are more susceptible to being swung around by market rotations”.

Another issue to consider in a balanced US equity portfolio is how the strength of the dollar impacts it.

We believe the underinvestment will result in an extended pricing cycle for energy.Alec Murray, Amundi US

Eric Papesh, portfolio specialist for US equities at T Rowe Price says: “Investors need to understand the specifics of the individual businesses within their portfolio. You not only need to know where their sales occur, but what their cost base looks like as well. 

“Are the revenues and expenses in the same currency, or is there a mismatch between the two? Does the company hedge their FX exposure, or are they exposed to fluctuations in exchange rates?”

Opportunities

In terms of opportunities in US equities right now, Smith is looking for companies with improving fundamental characteristics, “where that future improvement is under-appreciated by the wider market and not fully embedded in the current valuation”. Stocks like Coca Cola, Microsoft, Hilton and Vertex are among those he is excited about.

Several managers believe energy and financial services are attractive.  

Speaking about the energy market, Amundi's Murray says despite higher oil prices, energy companies have been slow to increase capital spending. This is out of concern they will not earn an attractive return on investment, given the global shift towards alternative energy.  

The credit risk to the higher quality financial services stocks in our view is minimal.Alec Murray, Amundi US

He says: “We believe the underinvestment will result in an extended pricing cycle for energy, which will support earnings for energy companies as well as the stocks.”  

Many financial services companies, meanwhile, are benefitting from wider net interest margins as interest rates increase, he points out.

Murray adds: “While credit quality will inevitably weaken as the US economy slows, the credit risk to the higher quality financial services stocks in our view is minimal.”

Cautious approach

Diversification means trying to balance the opportunities against the risks to US equities, of which the biggest are high and persistent inflation, rising interest rates, slowing growth, a strong dollar, and margin pressure from companies forced to raise prices due to higher input costs. 

For Columbia Threadneedle’s Smith, this earnings season is going to be “especially important”.

“We are looking for it to shed some light on how companies are navigating these many and varied issues,” he says.

Fidelity is taking a cautious approach; in general, Fidelity Solutions and Multi Asset funds remain defensively positioned, with cautious views on the outlook for equities and fixed income overall, given a deteriorating macroeconomic backdrop – but it prefers US equities to other regions. 

A closer look suggests the deteriorating macro picture is not yet priced in.Ayesha Akbar, Fidelity International

Akbar explains why: “Despite stubborn inflation and a hawkish Fed, data in the US seems to be holding up more resiliently than the UK or Europe.”

Within a US allocation, it makes sense to avoid areas such as technology and to pay particular attention to valuations over the coming months, she says, as we move through the current earnings season.

She points out: “In many areas of the market, while broad equity indices are down significantly from their previous highs, a closer look suggests the deteriorating macro picture is not yet priced in, posing further potential downside.”

At this stage, Fidelity sees US equities as attractive relative to other regions, but would be cautious on adding significant equity risk overall to portfolios.