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Why style differentiation matters in US equity investing

The influence of a fund’s style is important, especially when investing in such an efficient and broad market as the US equity space.

To give an example, the 10 top-performing funds over the past five years in the IA North America sector all happen to sit in the large-cap growth space according to Morningstar, whereas the IA UK sectors do not distinguish between styles.

Name Morningstar analyst rating Total return annualised 5 years (daily) GBP
Baillie Gifford American B Acc 25.48
MS INVF US Growth Z 24.27
Seilern Stryx America USD U I 23.13
T. Rowe Price US Large Cap Gr Eq Q GBP Bronze 22.88
Vanguard US Opportunities Inv GBP Inc 22.66
T. Rowe Price US Blue Chip Eq Q GBP Gold 22.52
MS INVF US Advantage I Silver 21.83
Loomis Sayles US Equity Leaders N/A GBP Silver 20.89
Legg Mason CB US Lg Cp Gr X USD Acc 20.57
UBS US Growth C Acc 20.55

Technology was the best-performing sector over the past five years, with the S&P 500 Technology index returning 27.6 per cent per year (in sterling terms) compared with an annualised return of 18.6 per cent of the S&P 500. The sector has been driven by big gains from most technology subsectors, including software, Internet, semiconductor, and hardware. When you drill down at the stock level, you see further light.

The 10 top-performing stocks in the S&P 500 over the past five years were in the high-growth areas. They included technology companies such as Nvidia, Advanced Micro Devices, Take-Two Interactive Software, Broadcom, and Adobe Systems; biotechnology names such as Abiomed, Align Technology, and Nektar Therapeutics; as well as Internet retail businesses Netflix and Amazon.com. The latter two have both been classified as consumer discretionary, although they are seen by many investors as technology stocks.

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In addition, technology has become a more significant part of the US equity market. Over 10 years, its exposure has increased from 16 per cent to almost 26 per cent in the S&P 500 and from 28 per cent to 42 per cent in the Russell 1000 Growth index.

The change is mainly due to the emergence of “new technology” companies, such as Alphabet, Facebook, and Apple, which quickly started dominating the US market. However, to address the issue of technology sector dominance, major changes have been put into effect.

S&P made changes to how some technology companies are categorised in the S&P 500. Effective on 24 September, a new communication-services sector replaced the telecommunications sector.

Netflix moved to this sector and will now sit alongside Alphabet, Facebook, Twitter, Activision Blizzard, and Take-Two Interactive Software, which used to sit in technology. The communication-services sector will represent roughly 10 per cent of the S&P 500 and will consist of 26 stocks, while the telecom sector was 2 per cent and had three stocks.

The technology sector was reduced to approximately 20 per cent. The new communication-services sector is going to have a growth bias and will be more cyclical, whereas the previous telecom sector consisted of 100 per cent value stocks and was more defensive. That said, despite the weighting reduction of the technology sector, investors remain sceptical that this reshuffling of widely held stocks will solve the problem of their influence on the US market’s performance.

The dramatic outperformance of high-growth stocks has resulted in the growth style significantly outperforming value-based strategies over one, three, five and 10 years. That said, calendar-year returns differ, and there have been pockets of the value style outperforming, such as 2012 and 2016. In addition, the value style has outperformed growth over 20 years.

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The recent extraordinary rally by growth funds has left investors wondering if that trend may have gone on for too long and if they should expect a sharp rebound.

While some commentators believe US Federal Reserve policies are creating a good environment for continued growth stock outperformance, others think that high-growth sectors such as technology, consumer discretionary, and some parts of healthcare are already overvalued and that there are more-attractive opportunities in traditional value sectors such as financials and telecoms.

Unsurprisingly, some of the best-performing funds’ valuations are also quite high. For example, as of 31 August, Baillie Gifford American’s p/e was 44, Morgan Stanley US Growth’s 35, Loomis Sayles US Equity Leaders’ 32, and T. Rowe Price US Large Cap Growth Equity’s 31. The average fund in the US large-cap growth equity Morningstar category had a p/e of 29, while the average US large-cap value fund’s p/e was 18.

Given that different investment styles may work better at different times and shifts between the style leadership can be dramatic, we believe in pairing growth and value styles to achieve core US equity exposure. The following US large-cap growth funds are rated highly by Morningstar: T. Rowe Price US Blue Chip Equity, Capital Group AMCAP, and PGIM Jennison US Growth.

Lena Tsymbaluk is an analyst in manager research at Morningstar

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