Of the world’s total equity market, 50% is in the US. Yet, many commentators argue that it is still very overvalued. So, if European institutional investors cannot afford to ignore what is happening in the US, how should they control their exposure to it?
Historically, in the US, equities have generated 6-7% real return, which is what drives thinking. US domestic investors are very backward-looking; according to Kerrin Rosenberg at Hewitt Bacon and Woodrow, the general view is: “Our equity market will give 6-7% real even if European stocks may be a bit shaky.”
Against this backdrop however, there are the long-term bears of the US market. Jeremy Grantham of GMO, argues that the US market is still experiencing the aftermath of the TMT bubble. Looking at long-term historical trends suggests that the S&P 500 is greatly overvalued and “will go back to trend line fair value sooner or later”, a level he sees as closer to 730 than around the current market level of 1200.
Drawing near-term conclusions from a long-term mean-reversion analysis of market valuations can be very misleading, particularly as timescales for getting back to a trend line may be beyond the time horizons of the investors. For Europeans, this approach may be meaningless in any case. As Rosenberg points out: “There is an enormous cultural difference between the US and Europe. The European viewpoint starts with the economic views going forward. The past is much less important.”
David Cameron of Boston Company Asset Management concurs with this view. “Each economic cycle over the last 30 years has moved the world’s markets increasingly toward an integrated global economy. Today, investors must pay significant attention to the balancing act occurring between production and supply in Asia versus consumption and demand in the US. Even with modest rate hikes, US monetary policy remains favourable to consumption, which in turn supercharges growth in Asia. Asian currencies are pegged to the dollar. As long as the Asian policy makers continue to funnel current account surpluses back into US debt, the environment is stable.”
A commonly used indicator of value in the US equity market is the so-called ‘Fed Model’ that simply says the market is fairly valued when the forward looking earnings yield based on consensus earnings is equal to the yield on 10-year government bonds. When valuing the US equity market, Cameron’s team uses an adjusted Fed Model, adding in factors for manufacturing productivity, inflation and currency valuation, which they see as improving the model’s efficacy by about 40%.
Testing today’s prevailing scenario, they assume that Asia continues to create huge global savings, buys US treasury and agency debt, US interest and inflation rates remain subdued and the value of the US dollar erodes at a steady but orderly pace: Productivity remains robust. With these inputs, US stocks appear 18% undervalued. In a more bearish scenario, Cameron assumes Asian deflationary pressures abate and inflation becomes a problem: productivity falls and interest rates rise. Under this scenario, the market appears about 13% overvalued.
The base case is somewhere in between, suggesting a few percentage points of equity market undervaluation. Readings at these levels are within the range of ‘noise’ in the model, leaving nothing to move Cameron to either a strong bearish or strong bullish outlook.
With value and growth stocks seemingly fairly valued relative to one another, and small-cap stocks catching up on valuations of large stocks, this leads to an ‘asset allocation nightmare’. So how should European investors approach investment in the US equity markets?

The key to controlling exposure to the US market is to recognise that it is not one market, but a collection of smaller markets that can be defined by style and size. The dilemma is that if fund managers are meant to be hired on investment skills, as Rosenberg argues, “you should give as much freedom as
possible to fund managers to make investment decisions, which means removing geographic constraints, so ideally we want global mandates”.
The problem with such mandates is that exposures can be set by geographic constraints with exposures to the US obtained through narrow benchmarks. As Darrell Riley of T Rowe Price points out: “Lots of foreign investors own S&P Depositary Receipts – which mimic the S&P500 Composite Stock Price Index – and wonder why they missed out. The reason is that they didn’t have broad exposure.”
However, as Rosenberg admits, the global opportunity set is too large for even the best-resourced managers to adequately analyse. The US equity market alone has around 6,500 listed companies. While the 250 largest capitalisation stocks accounting for 70% of the market cap tend to be well researched, many small and mid cap stocks might have only one analyst covering them, making them an attractive area to seek outperformance. It is easy to forget that the
total capitalisation of the US small
and mid-cap segments alone is larger than the entire Japanese market.
The sheer size and scope of the market means that investors “are forced to have some specialists and the purpose is to give access to all opportunities, including some of the niche ones”, according to Rosenberg. However, in contrast to US schemes which split the US market into lots of boxes and use lots of managers for diversification, Rosenberg sees the role of specialist managers in the US equity market as giving the ability to access inefficient pockets, a strategy not required everywhere.
As T Rowe Price shows (figure 1), there is a plethora of indices that cover the US market across size and style, besides the popular S&P500 that can dominate the approach of foreign investors. For example, the chart shows that the top 30% of the capitalisation of the Russell 1000 value benchmark consists of companies with capitalisations greater than $100bn (e75.5bn).
Riley argues that “irrespective of valuations, you need broad exposure”, which generally is seen as equating to using a benchmark like the popular Wilshire 5000 “which sees investment opportunities way down the market cap spectrum”. Taking a style view often means taking a view on sectors with financials dominating the value index, and information technology and healthcare dominating the growth indices.
Taking a strong style bet can either explicitly or implicitly prove to be
disastrous if sentiment shifts suddenly, as happened during the TMT bubble when large-cap growth spectacularly outperformed, only to crash with a value comeback that followed in 2002 and 2003. As Riley points out, many institutional investors found themselves in the situation of having four US managers, all of whom had a strong bias to large-cap growth stocks, so they suffered when value stocks swung back.
Currently, there is a “blurring of the distinction between growth and value”, according to Riley, and the key message is the importance of having exposure to the broad market in order to dampen volatility. Small-caps have outperformed in recent years driven by a mixture of the cyclical upturn in the US economy, falling interest rates and the huge liquidity
of funds boosting appetite for
more speculative assets, as well as the normalisation of valuations relative to large-caps. The “outperformance should end for small-caps at some point as the persistence of the factors giving rise to it is unlikely”, says Riley. He adds: “Although we believe
small-cap has less value than a few years ago, there are still some attractions there, so we still keep some chips on the table.”
The important thing to consider is the use of benchmarks. Riley argues passionately for the use of a broad benchmark to set the universe of investment opportunities while distinguishing between that and the indices used for performance comparisons. “Clients often say they want their portfolio to look like a Wilshire 5000, to ensure they have coverage of smaller stocks, but they want performance and tracking error to be measured against the S&P 500, or on multiple benchmarks.”
It is not surprising that the greatest diversity of fund managers is to be found in the US market. This reflects not only its size, but also the strength and depth of the academic community in finance and economics that has spawned countless new fund management companies. Investment consultants in the US have encouraged the growth of domestic equity mandates structured by size and style with multiple managers. European investors by contrast, with a few US equity managers at most, need to be very aware of what total exposure they are able to access through their choice of managers.

For a European institution looking at how to approach the US market, a clear framework for evaluating the options through a disciplined risk budgeting approach is required.
Depending on the risk appetite, options range from the lowest risk index managers to the risk-controlled enhanced index approach aiming at 1-2% outperformance to get to the traditional active managers, with typically 3-4% outperformance targets, and finally the absolute return or hedge fund managers for whom tracking error against a benchmark is irrelevant.
Choosing how to access the broad investment universe within the desired risk parameters requires decisions to be made on how to access the specialist skills required to tap into the inefficient niches within the broad market, as well as the most liquid top 250 stocks. The choices essentially revolve around:
q Using a heavily quantitatively driven firm that can use the same process across the entire market spectrum;
q Using multiple managers defined by size and style following the methodology of US institutional investors;
q Using one or more multi-asset managers who have capabilities in all major US market segments.
Firms with strongly quantitative processes cannot argue that they are able to use essentially the same process to cover the complete market as well as sub-segments, and in some cases, operate at different risk levels as well.
Barclays Global Investors (BGI) uses the same active quantitative process throughout the world, running alongside both their index funds and hedge funds. Other firms, such as GMO, have essentially the same process with slight variations arising from having semi-autonomous groups in the US, Europe and Australia.
Paul Timlin of Citigroup Asset Management, describes the US quantitative equity capability as predicated on alpha forecasts that are “designed to be independent of sector, size and style effects, and our portfolios are neutral to most systematic factors. We hope to add value above the benchmark in most scenarios regardless of whether the market is up or down, interest rates are rising or falling or growth versus value is in favour.”
GMO, while characterised as a value firm, also tries to adopt a style-neutral viewpoint by dividing portfolios into a fixed allocation between value and momentum sub-portfolios. First Quadrant argues that it is able to take advantage of style shifts through active tilting of its portfolios.
The size of the US marketplace has spawned a huge number of specialist players occupying particular niches very successfully, such as Friess Associates, which manages only US growth stocks, and Dimensional Fund Advisors, which runs portfolios of US small-cap stocks with up to 3,500 stocks in them. Even within an equity-only fund manager, such as the Mellon-owned Boston Company Asset Management, the requirement to manage value and growth US equity portfolios across the full capitalisation range has led the organisation to be organised as separate semi-autonomous teams, each managing a particular segment. Cameron says, while they all have strong research driven processes with lots of time with company management, the implementation can vary from team to team, which “is appealing in that it allows us to tailor our approach to specific challenges in each segment of the US equity market”.
A number of financial companies have responded to the large opportunity set in the US market by owning separate fund management firms
that have significantly different approaches. For example, according to William Battersby, Mellon Global Investments “offers a number of complementary strategies. We offer pure indexation through Mellon Capital, enhanced indexation through a stock-ranking process and optimiser at Franklin and at Mellon Equity. We can offer traditional bottom-up stock selection strategies through the Boston Company Asset Management, where 85% of the active risk is stock specific and the more top-down thematic approach of Newton.”
Some large multi-asset firms that seek to offer very broad capabilities, such as T Rowe Price, have tackled the requirement for sector expertise within the US marketplace by organising themselves as a collection of boutiques with individual portfolio teams specialising in each market
segment, and sticking to strict size and style guidelines, while sharing common research. T Rowe Price argues that by having very low staff turnover, with managers spending decades with the same firm, style stability is assured. As well as offering individual specialist products, such as small-cap value or large-cap growth, products can be blended to provide a broad exposure across styles and range of market cap, weighting those segments which are deemed to be undervalued.
The message that European institutional investors need to bear in mind is the need to devote as much thought to structuring their US equity portfolio as they do to the rest of their equity allocation. In particular, managers should try and ensure that all the segments of the marketplace can be covered, not just the large-caps.

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