Professional Adviser – North American Sector Review

The US equity market is notoriously difficult for active fund managers to outperform consistently because it is arguably the most efficient major stock market in the world.

As a result it makes a challenging task for professional advisers, fund selectors and discretionary fund managers to select funds and strategies to provide exposure to the sector.

Within the US equity market, fund selectors have three major indices to choose as the basis of their exposure – the larger S&P 500 for blue chip, large cap companies, the Nasdaq, historically home to tech and biotech businesses, or the Russell indices, which traditionally are for small and mid-cap companies.

But these general descriptions of the indices does not give an accurate account of the companies and parts of the economy to which they provide exposure and importantly how they will perform going forward.

For example the Nasdaq, because of its high exposure to the technology sector, historically performs better when the economy is in a recovery phase because companies and individuals spend more on technology than during recession.

US equities cannot be ignored using standard asset allocation models because America comprises the largest individual segment of the MSCI World Index, which is the benchmark for many models.

But it is the market which so quickly moves between growth and value stocks or the economic cycles making it notoriously difficult to select a portfolio of funds.

Currently the market is in a growth phase which is likely, given the positive economic data and the impact of tapering, to move into a momentum phase. But timing that switch and moving fund exposure accordingly is nigh on impossible to get right.

This creates a series of problems for advisers with clients in mind. Do they select an active fund, try and understand which environment it will perform in and then advise accordingly? There is the risk the outcome for the client may not be one they are expecting and few clients understand that active funds do not perform in all environments.

Increasingly DFMs and some multi asset funds are using an approach of mixing both active and passive funds in the form of either index or structured investments combined with a suite of active funds.

Even this approach is not an ideal solution because both active and passive funds are susceptible to the rapid changes in the economic and market environment, particularly in the US.

So what can advisers do? Potentially one solution to the US is to take a forward looking view to fund selection, rather than using the historic method of selecting funds based on their past performance in the hope that they will perform well in the future.

 

The PureResearch Group Forward Perspective ratings are based on a systemic analysis process created by two US professors Dr Russ Wermers and Dr Alan Timmerman through their firm Parala Capital

The work of the professors, which has been published in a series of US academic journals, shows that key economic factors such as interest rates, rising or falling GDP, or default spreads, directly relate to the performance of an asset class and this performance is likely to be repeated over an economic cycle.

Their research can be used to differentiate between active fund managers – put simply identifies which managers display consistent skills or alpha, and those managers who actually just provide market return, or beta, but charge investors as though they were providing alpha.

It can also be used to differentiate between passive managers as well because the research shows that even passive funds which track the same underlying indices are likely to perform differently from each other, albeit clearly the differences between passive and index products is not as profound as it is between active managers.  That being said, asset classes or sectors these funds track will also have difference expected performance given the economic environment for which the research helps identify.

The PureResearch Forward Perspective ratings provide a twelve month forward looking view of how a fund is likely to perform which can be combined with the established ratings organisations which provide an historic view based on quantitative performance criteria with qualitative opinion, i.e based on an interview with the fund manager or fund group.

Top 20 performing funds over the coming 12 months (full analysis click here)

North American Sector Analysis - 14JAN2014 (Chart 1)

The PureResearch analysis shows that based on underlying Morningstar data as at the 31st December 2013 the top 20 funds on a forward looking view are a combination of active managers such as Threadneedle Investments and Janus, and passive managers such as Amundi, iShares and Lyxor.

Interestingly the research shows how it is possible to select funds from the same management group to get both active and passive exposure. Janus has two active funds in the top 20 list, but it also has a passive fund through its affiliate INTECH.

INTECH’s US Core fund provides a systematic passive strategy to large cap companies within defined risk metrics, while Janus’ US ALL Cap Growth or US Research funds provide active approaches to broad based American equities.

Largest fall in rating between June and December 2013

North American Sector Analysis - 14JAN2014 (Chart 2)

This ‘forward-looking’ style of analysing funds also helps analysing which funds are likely to underperform or perform less well going forward. GAM North American, for example, run by the highly experience Gordon Grender has moved to a 2 rating, where 5 is the highest rating, which is in line with the more defensive long term style which Grender employs.

The solution to selecting funds for the US proportion of a client’s portfolio is a combination of both active and passive funds, and it is possible to create a suite of both styles which will perform well at the same time going forward.

Patrick Murphy is Director at PureResearch Group. www.pureresearchgroup.com

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