The challenges of managing money in the US equity market and outperforming the index over the long term are well known.
First, gaining an information edge, particularly in the larger-cap arena, is tough. Second, regulatory constraints have left fund managers increasingly concerned about inadvertently obtaining information from company management not in the public domain and having to declare themselves insiders.
The third challenge is bulk trading activity. The growing presence of ETFs and high frequency trading vehicles in the US market makes it difficult for fundamentally driven, longer-term investors. Arguably, this indiscriminate activity should also represent an opportunity for long term investors. However, few managers enjoy the privilege of a loyal investor base patient enough to allow such strategies to reach fruition.
Finally, the S&P 500 itself is akin to an actively managed fund. The S&P 500 Index Committee’s mission is to ensure it represents the US equity market, with a focus on large caps. Company size, liquidity, minimum float and balance all have a part to play in the decision-making process but the committee has some discretion in selecting stock and responding to market events.
According to Morningstar Direct, the IA North America sector average has underperformed the S&P 500 over one, three and five years.
Fund managers are trying to outperform a moving target. This is a harsh regime for those in the core space attempting to provide clients with a smooth relative performance path. As passively managed products have become cheaper and easier to access, it is difficult to argue against their use for investors for whom beta and short-term relative performance is more important than alpha.
Introducing spice to a portfolio via active funds can be an interesting way to add value when you are holding a passive fund for the core. There is the choice of having structural holdings in value and growth funds for the long term or taking a more tactical approach and tilting the portfolio towards one style or the other.
The trick with the latter is in timing. Such funds can have powerful bursts of performance but they are also vulnerable to periods of meaningful underperformance when their styles are out of favour.
Like most other markets, growth funds in the US have been running hard. They have benefited from investors’ search for anything that is, or is perceived to be, growing. Growth’s outperformance of value has mirrored the 10-year US treasury’s march downwards to today’s ultra-low yields. This trend has been particularly strong since 2008. The rampant performances of Facebook, Amazon, Netflix and Google during 2015 demonstrate this enduring trend.
In terms of market dynamics, there are signs of a shift. Last year was dominated by anxiety about China, the parlous state of the oil-dependent emerging economies and concern the elevated debt pile accumulated by emerging markets might prove overwhelming, particularly when combined with a cyclical downturn and a disruptively strong US dollar. All eyes have been on the US to drag the global economy away from a deflationary spiral. While the economy has mustered some growth (2.4 per cent GDP in 2015), it has been losing momentum right at the moment when investors have realised central bankers are out of monetary bullets.
At the company level, profits are falling. Margins in the US peaked in the first half of 2015. For years, earnings have been inflated by lower taxes and interest payments: profitability boosts that cannot be repeated.
The stockmarket is not priced for disappointment, least of all the beloved growth stocks. Meanwhile, value stocks, which are under-owned and unloved, appear to be in a bottoming phase and are even showing signs of relative outperformance, particularly at the small- and mid cap level.
We continue to be cautious on the short-term outlook for US equities as aggregate valuations remain elevated in the face of a challenging forecast of improved profitability.
Gill Hutchison is head of investment research at City Financial
It is a good time to emphasise value funds. JP Morgan US Equity Income is relatively conservative in its approach and managed with a value style.
For extra spice, the IA North American Smaller Companies sector’s Legg Mason Royce US Small Cap Opportunity has felt the full force of value and small-cap underperformance.
Aside from those two funds, we only feature three more from the IA North America sector on the basis passive funds are often the logical option for US equity investment.
Axa Framlington American Growth is managed with a strong growth style and a mid-cap bias.
Legg Mason ClearBridge US Aggressive Growth is a high conviction portfolio invested in companies with defensible growth prospects.
Schroder US Mid Cap is a growth-biased, thoughtfully managed portfolio of small and mid-cap companies.