Weak dollar hits US equity fund returns

At first sight, investors in US equity funds seem to have been well rewarded in the six months to the end of February 2007, with an 8.4% return from the median mainstream fund only marginally short of the S&P 500’s 8.9%.

However, as explained by Standard & Poor’s Fund Services, the leading provider of qualitative fund management ratings, in its latest update on the sector sterling and euro-based investors saw these gains slashed by the weakness of the dollar. In sterling terms, the S& P 500 returned only 5.7%, against 5.6% in euro.

At the same time, in local currency terms the US market lagged all other regions except the UK. Said Standard & Poor’s lead analyst Alison Cratchley: “The weakness of the US dollar against all major currencies except the yen meant that US $-based investors would have made more money investing anywhere outside the US, apart from Japan.”

Despite this underperformance of the US relative to other world markets, S& P’s Cratchley found most fund managers positive on the outlook, taking the view that valuations are attractive for US companies with strong balance sheets and a high level of cash generation. “As the fund managers see it, stocks are still inexpensive against the current level of bond yields,” she said, citing the example given by the team at the S& P AAA-rated Findlay Park American Smaller Companies Fund, pointing out that the US equity market has an earnings yield of 6.9% on 2007 earnings, which compares favourably with 10-year bond yields of just 4.65%.

Valuations are also seen as favourable by Marvin Schwartz and Henry Ramallo of the S& P AAA-rated UBAM – Neuberger Berman US Equity Value Fund. Their view is that a multiple of 14 x 2008 earnings for the S& P 500 is modest, particularly given that inflation is at a 20-year low. They see the market as underpinned by private equity activity and other technical factors.

With the economy slowing, several fund managers are finding value in larger companies. The team at Baring Main Street US Fund said its models had been indicating for a year that the cycle of small-cap outperformance that began in 1999 was coming to end. This had caused a move up the capitalization scale, yet to be rewarded but likely to continue. At the A-rated Gartmore US Focus Fund, Chris Baggini is finding most value in larger-cap names, particularly multinationals such as QUALCOMM. Meanwhile, at Gartmore US Opportunities Fund Gil Knight has raised exposure to large-caps from 64% in September to 73%. In the small- and mid-cap sector, the team at Findlay Park has also been moving up the cap-scale on the view that mid-caps are providing many of the best opportunities with the least risk.