For investors looking to build a globally diversified portfolio, the argument is strong for going passive for US equities. That’s because the blue-chip S&P 500 is seen as the most efficient market in the world and therefore investors - professional and individual like - find it hard to get an edge.
It’s also “an incredibly diverse index”, says Gary Potter, co-head of multi-manager solutions at BMO GAM. He adds: “Even with the advent and progress of the FAANG stocks over the last 18 months, the S&P 500 remains one of the most diversified global stock market indices.”
Over the past decade, investors would have been very well served by parking their cash in a US tracker and leaving it there.
A $10,000 lump sum investment in the Morningstar Gold Rated HSBC American Index tracker on 9 March 2009 would today be worth just shy of £50,000, data from Morningstar Direct show. The average fund in the Investment Association North America sector has returned £42,000.
Active management advocates would argue, of course, that this is an unfair comparison. Still, over the five years just 7% of surviving funds in the North America sector have beaten the best-performing tracker.
The only equity region with a passive as the best-performing fund over a 10-year period to 31 December 2017 was the US, research from BMO GAM shows. Furthermore, the average passive product in the US market outperformed the median fund across all rolling time periods over the five years to end-2017.
Since the financial crisis, Governments the world over have resorted to extraordinary monetary policy in the form of quantitative easing – creating new money to purchase large quantities of Government bonds. Central banks, led by the US Federal Reserve, have made trillions of dollars of purchases.
Many believe QE and low interest rates have served to artificially boost asset prices across the board, from bonds to equities to property – even things like vintage cars and fine wine. This “rising tide to lift all boats environment has been “a great breeding ground for passive investing”, according to John Husselbee, head of multi-asset at Liontrust.
Only Downside From For Trackers Here?
Earlier this year, David Rosenberg, chief economist at Canadian firm Gluskin Sheff, claimed “the Fed was responsible for 1,000 point S&P 500 rally this cycle”.
Now, central banks are looking to normalise policy and scale down their balance sheets, with the Fed by far the furthest through this process. The new environment “should create greater dispersion among stocks and more opportunities for active managers to exploit”, adds Husselbee.
If Rosenberg’s assertion is correct and quantitative tightening has the opposite effect, “then one can see that there could be a lot of potential downside over time”, says Neil Dwane, global strategist at Allianz Global Investors.
Should this be the case, those with cash sitting in funds that track the S&P 500 could be in for a shock, so the argument to switch back to active managers in the US may never be stronger.
Simon Evan-Cook, senior investment manager on Premier Asset Management’s multi-asset fund range, agrees: “Given the fact that US market trackers have had such a good run against US active managers in recent years, we think this is a trend that looks ripe for a reversal.”
Financial advisers may already be heeding this advice. Three of the 10 most recommended funds on AJ Bell’s Investcentre platform in 2018 were passive; none of them were US-focused. Of the two North American funds in the top 10, none were passive.
The S&P’s record-breaking bull market “has come to a shuddering halt” in the fourth quarter of the year, says Algy Smith-Maxwell, manager of the Jupiter Merlin Real Return fund. The index is down 12% in the quarter-to-date and 5% year-to-date.
“History tells me that active managers often build their reputation through bear market outperformance; sadly, index trackers do not have the freedom or flexibility to do this,” adds Smith-Maxwell.
This sentiment is echoed by Adrian Lowcock, head of personal investing at Willis Owen. He notes that active managers tend to suffer towards the top of a bull market, but should be better positioned when the market turns.
That's because they can seek out exposure to areas that offer the best risk-adjusted returns, while avoiding areas that have become too expensive or have been driven up by momentum of passive money.
It’s something Potter and his team have seen coming for a while, and their Lifestyle funds currently have their lowest allocation to passives ever. “That’s a reflection of the fact that I do fundamentally believe we are entering a different zone in the outlook for world markets.”
He makes the point that if you’d bought index trackers at market peaks in September, you’d be down around 11% in the UK, 13% in the US and almost a quarter in Germany. “There are some active managers that are down half of that.”
Simon Molica, active portfolios fund manager at AJ Bell, agrees that it looks like “a more compelling time for active management in general”. “The discrepancy between value and growth has grown to such wide levels that active management should be in a good position to take advantage of a strong rebound in value if that were to occur.”
Which Active Fund Should Investors Choose?
Despite his strong feelings on the need for investors to move back towards active management, Potter cautions that picking the right manager or team is important, because “there is quite a lot of dross out there”.
Potter’s key recommendation is to look for funds with high active share, which is a measure of how much a portfolio’s holdings differ from their benchmark index. “You want to find a manager who if they don’t like a stock don’t own it, rather than have an underweight position,” he explains.
One of those he likes is Ian Heslop’s Morningstar Silver Rated Merian North American Equity fund. “Although that’s a directional trend-following approach, systematic in many ways, he has a very high active share.”
Smith-Maxwell likes Findlay Park American, which he says has an impressive long-term track record despite running a high cash weighting of between 8-18% since its 1998 launch. This allows them the flexibility to pick up stocks they like at attractive valuations as and when they crop up.
“Their current cash weighting is circa 15%,” he adds, “which tells me that there are a whole raft of stocks in the US market that are still too expensive for them to buy. I expect that they will deploy some of this cash when there is blood on the streets and prices are cheap.”
Husselbee is a fan of the blended approach, with Silver Rated JPM US Equity Income, run from New York by Clare Hart, well-placed to capture a recovery in value. He also holds UBS US Growth and the Gold Rated passive Fidelity Index US.
One fund that has historically done well in falling markets, according to Nick Wood, head of fund research at Quilter Cheviot, is Alabama-based Vulcan Value Equity. The manager looks for attractively valued firms with inherent underlying growth, leading to a higher-quality value portfolio.
“While we are not predicting a major correction in the US, the combination of protecting assets in a falling market and being willing to take advantage of share price declines should make this a good environment for the fund,” adds Wood.
When correlations in markets are high and dispersions low, it is very difficult for stock pickers, says Frank Thormann, manager of the Schroder ISF US Large Cap fund. However, “if dispersions start to widen, those would tend to be markets where active managers should do much better”.
Thormann, who has sold both Netflix (NFLX) and Facebook (FB) this year, says opportunities he is finding at the moment are in companies with pricing power. Healthcare is one such area.
“We’ve found quite a few companies that are able to innovate and come to market with good products. They should have a very promising bright growth outlook and that growth should be achievable somewhat independent of an economic cycle.”
