What the US return to 'normal' means for US funds

Investors are on tenterhooks about how and when rates will rise from their 2008 rock bottom, with disagreement rife about what the rampant strengthening of the dollar and slow wage growth could mean for that timeline.

We asked four US fund managers what they thought of the state of the US economy, and what a period of US recovery punctuated by an oil price shock and soaring dollar meant for them.

WHAT'S THE STATE OF THE US ECONOMY?

Thorsten Becker, senior fund manager of JO Hambro US Small Mid Cap Equity (IE00BQT49290):

"Unemployment has dropped to 5.5 per cent and there are early signs that wage growth might be picking up so things are good enough now that rates could return to normal levels. We've had an extremely long period of close to zero rates so even an acknowledgment that the US is no longer in emergency mode would just create a more normal environment."

Tom Digenan, manager of UBS US Equity (GB0032004326):

"Yellen is very sensitive to real wages and even though unemployment has gone down, the labour rate has not. There also isn't much wage growth, though Walmart has raised wages and Target has announced it will follow.

"But I don't understand this thing about not wanting volatility. There is risk in stocks, you get compensated. The Fed is trying to walk such a fine line that it has to signal absolutely everything. I might become an English major if this word patient is so important."

Mark Sherlock, manager of Hermes US SMID Equity (IE00B8JBC584):

"I think there's a risk that the Fed leaves it too late and is too cautious. The fear could be that you're storing up inflation problems for 3-5 years out. But we're a long way off that now.

"You do wonder if there hadn't been such a strong dollar recently whether it might have considered putting up rates in the first half of this year rather than the second half but a strong dollar does have a dampening effect on the economy and they are very keen not to get it wrong by tightening rates too early. Our view is that rates will rise very moderately and will be very well telegraphed. They don't want to spook the market."

Dan Harlow, deputy fund manager of AXA American Growth (GB00B5LXGG05):

"There have been inevitable concerns over rate increases in the US, however, the US Federal Reserve is unlikely to need to aggressively hike rates. When it is time for them to rise and when they do, it is worth remembering that they will be doing so from an artificially low level to a more normal one."

WHAT ARE US MANAGERS DOING?

These managers say they've had a tough time but all believe 2015 will bring back a focus on value and stock picking. Until now, the liquid market due to the inflow of cheap money from the US quantitative (QE) programme combined with low rates has left investors in the US clamouring for yield and flooding to high dividend-paying defensive stocks which act in a similar way to bonds, rather than to value-orientated smaller companies.

At the same time, increased correlation between stocks and the efficiency of the market has made it difficult to spot value and money has flooded out of active funds and into passives.

Mr Becker's concentrated fund of 45-60 stocks has returned 7.30 per cent since inception in September 2014 compared with 10.09 per cent for the benchmark. He says: "Last year there was a lot of back and forth in trying to guess which way macro drivers would go and where rates would end up, and it was hard for managers to beat the market. But as we go back to a more normal macro environment I think it will be better for stock picking."

His fund is investing in energy infrastructure and technology including drilling equipment in a bet that those stocks will perform even if the oil price continues to drop. "I spend a lot of time on energy now. The price has come down more than 50 per cent from the top and it’s just a matter of picking the right companies."

The strong dollar and oil price fall have both impacted Mr Digenan’s UBS Equity fund, which invests in predominantly large-cap US equities from a bottom-up stock picking perspective. He says assets in his portfolio such as Philip Morris (OM8V), which generates all its revenue from outside the US, were hit by the strong dollar, as well as companies like Yum! (0QYD) and Mondelez International (0R0G).

"Those are companies that are great franchises and strong businesses, so even though you will have short term volatility on earnings based on currency, I wouldn't shy away from them," he says.

"I was underweight energy last year and have neutralised the energy bet now. I don't think we're out of the woods when it comes to oil prices and we don't know where the bottom is. But we saw potential in some of the oil services stocks so I spread it out among four or five names in those spaces which really got hit but looked attractive and had a bit of a safety buffer in their balance sheets."

He is also very keen on banks, despite an overweight in Citigroup (0R01) resulting in a negative hit to the fund - the share price of the company fell by 9.9 per cent in January.

"Probably the most unpopular bet I have right now is that I'm long the big diversified banks - they look really cheap," he adds. "These companies are not going to get back to the boom days but they've completely deleveraged and the regulatory environment has scared a lot of people away."

Mr Sherlock believes the economy is at a crossroads: the end of QE and a potential rate rise could reverse the flows of money from high-yielding but potentially low quality companies, to a focus on company fundamentals and what he calls "the return of quality". The fund takes a long-term 3-5 year view and has not changed its positioning according to macro factors but is hoping that the end of QE-induced liquidity will add value.

"There was a 2014 phenomenon of people thinking small and mid-cap was expensive and switching out but we felt there was more of a story to be told.

"Now the taps of liquidity have been turned off people will be more aware of what they're buying because the cost of money will have gone up. Some of the things that helped favour of lower quality companies will be thrown into reverse, and there will be a return to focusing on cash flows and high quality businesses," he says.

Putting together a US portfolio

Adrian Lowcock, head of investing at AXA Wealth, says an ideal portfolio should be weighted around 15 per cent to the US but if your portfolio is not currently exposed to the market, it might be better to wait for valuations to reduce before investing.

Tim Cockerill, investment director at Rowan Dartington, says: "Exposure to the US is critical because it's the world's largest economy. Yes the valuation at this point is looking a bit on the expensive side so if you’re new to it you could put your money in in stages.We've got about 17 to 18 per cent in the US for our balanced model, and if you look at our adventurous model it's 23 per cent."

Mr Lowcock suggests a core and satellite portfolio approach, with a core made up of funds which tend to lose less in down markets and more niche satellite plays. As a core fund he likes JPMorgan US Select fund (GB00B2Q5DR06) because it is "well positioned for continued economic recovery". It has big exposures to financials, consumer services and healthcare.

As a satellite fund he likes Fidelity American (GB0003865176), managed by Peter Kaye. "He's looking for undervalued companies, and he does it through statistical analysis and crunching the numbers," says Mr Lowcock.

Mr Cockerill likes low cost tracker funds as core holdings like the S&P 500 tracker but also believes there is value to be had with actively managed funds targeting the mid and small-cap sectors.

He likes Artemis US equity (GB00BMMV4S07) and Threadneedle American Select Fund (GB00B7HJLD86). He also likes Threadneedle American Smaller Companies Fund (GB00B0H6DT06) for higher risk portfolios.

Artemis has outperformed the S&P 500 in GBP terms over one and six-month periods, and benefits from a sister company in the US providing it with research. In contrast, the Threadneedle funds are larger operations.

Adam Laird, head of passive investments at Hargreaves Lansdown, recommends Legal & General US Index fund (GB00BG0QPL51). "The FTSE USA index is broader than the better known S&P 500 and covers around 650 stocks, giving a good coverage of American equity," he says.

Mick Gilligan, head of funds research at stockbroker Killik, likes SPDR Russell 2000 US Small Cap UCITS ETF (R2US), a passive way of playing US small companies, which he argues have looked more attractive than large-caps for some time.

The PowerShares FTSE RAFI US 1000 Fund (PSRF) has gained popularity in recent months and was Investors Chronicle's fund tip earlier this month. It tends to be weighted towards value stocks.

 Performance of recommended US funds (% total return in GBP)

Source: FE Analytics, as at 20 March 2015.