Buoyed by a resurgent economy and solid earnings growth, U.S. equities have performed strongly this year, with the S&P 500 composite index posting a year-to-date return of 11.8% as of April 30. Energy was the index’s best-performing sector with a gain of 31.6%, followed by financials (23.5%) and real estate (18.1%).
During the first quarter, the U.S. economy grew at an annual rate of 6.4%, fuelled by massive government stimulus, declining Covid cases, businesses reopening, improving employment and a surge in business and consumer spending. The pace of U.S. economic growth in 2021 could reach the highest level in more than a decade, with pent-up consumer demand contributing to healthy corporate profits.
“[The] U.S. economy is doing exceptionally well from a macro perspective and is recovering quickly,” said Bill DeRoche, chief investment officer and head of AGFiQ Alternative Strategies with AGF Investments LLC in Boston. However, he cautioned that “markets look expensive, with very little room for expansion of multiples.”
DeRoche is co-portfolio manager of the $955.1-million (as of June 2) AGFiQ US Sector Class fund, along with Grant Wang and Mark Stacey, both with AGF Investments Inc. in Toronto. The fund’s F series had a return of 18.3% for the year ended May 31 compared with the 24.9% returned by the Morningstar US market GR CAD index over the same period.
The AGF fund offers exposure to 11 sectors in the S&P 500 by investing in specific sector-based SPDR ETFs. The AGF fund uses multifactor quantitative models “to assess equity risk exposure in the U.S. market, from both a macro and a micro perspective” and generate returns while mitigating volatility, DeRoche said. “Equity exposure can go up or down, depending on risk assessment of [the] market.”
For example, the fund could be overweighted by up to 6% in the two highest-ranked sectors and underweighted by up to 6% in the two lowest-ranked sectors. The remaining sectors could be overweighted or underweighted by 2%–4%. Overweighted positions are active and are intended to generate excess returns, DeRoche said.
Six factors are used in the AGF fund’s quantitative sector rotation process: value and momentum (the two largest factors), as well as size, profitability, quality and investor sentiment. In addition to the 11 SPDR ETFs, the AGF fund also uses a proprietary hedging product, the AGFiQ US Market Neutral Anti-Beta CAD-Hedged ETF, which takes long positions in U.S. stocks that have below-average betas as well as short positions in stocks that have above-average betas in specific sectors.
As of April 30, 96.2% of the fund’s assets under management (AUM) were invested in ETFs and 3.8% was invested in cash and cash equivalents. At that time, the Technology Select Sector SPDR Fund was the largest holding (25.9%), although the AGF fund’s exposure to technology was slightly underweighted relative to the sector’s market weighting of 27.6%, meaning the fund had a neutral position in technology, DeRoche said.
The largest active sector in the AGF fund was communication services. The fund had a 14.6% allocation to the Communication Services Select Sector SPDR Fund, representing a 3.8% active position in the sector compared with the sector’s benchmark allocation of 10.8%.
“Communication services is relatively inexpensive,” DeRoche said. “Profitability is improving, quality is good and it looks more attractive than other sectors.”
The fund took an overweighted position in communication services over the past six months while reducing exposure to materials, utilities and real estate. “Materials and energy continue to suffer from extreme valuations,” DeRoche said.
The fund was also overweighted in consumer staples (9.7%, compared with the benchmark weighting of 6.6%, which translates to an active position of 3.2%) through investment in the Consumer Staples Select Sector SPDR Fund. This sector is expected to perform well as consumer spending increases as the economy reopens, DeRoche said.
This year, up to 25% of the AGF fund’s U.S.-dollar exposure was hedged to the Canadian dollar. “We went from not being hedged to a 25% position,” DeRoche said. “[The] hedge was reintroduced because the risk for a good commodity run will benefit the Canadian dollar, and there is little ability for the U.S. dollar to do well, given inflationary conditions.”
Grant Bowers, senior vice-president and portfolio manager with the Franklin Equity Group, part of Franklin Resources Inc., said he’s bullish on the U.S. economy and U.S. equities this year and heading into 2022.
“[We] expect to see economic growth reach its highest level in a decade in the months ahead on the back of pent-up consumer demand and improving employment combined with unprecedented monetary and fiscal stimulus,” Bowers said.
Bowers is co-portfolio manager of the $371.5-million (as of June 2) Franklin U.S. Opportunities Fund with Sara Araghi, vice-president and portfolio manager with the Franklin Equity Group. Series F of the fund had a return of 15.5% for the year ended May 31, compared with the 24.9% returned by the Morningstar US market GR CAD index.
The fund’s long-term investment themes include the ongoing digital transformation driven by artificial intelligence, machine learning, cloud computing and cybersecurity, fintech, digital payments and health-care innovation.
“Portfolio positioning is the result of our bottom-up stock selection process,” Bowers said. “We try to look beyond short-term macro conditions to secular trends and tailwinds for growth.”
As of April 30, the fund had a 40% allocation to IT, a 17% allocation to health care and a 13.7% allocation to consumer discretionary. These sectors “have historically been and continue to be our largest portfolio exposures,” Bowers said.
In the technology sector, the fund invests predominantly in software and services, where secular growth trends are strong, Bowers said. In health care, the fund’s holdings are diversified across sub-industries. In consumer discretionary, the fund leans toward e-commerce.
Bowers said he’s “found interesting ideas” in industrials and financials. The Franklin fund has modestly overweighted positions in both sectors (7.4% and 6.4%, respectively).
One of the fund’s largest holdings is in California-based ServiceNow, Inc., which provides cloud-based IT service management for enterprises. Bowers said ServiceNow “has been steadily growing into a multi-product company providing an integrated platform to clients.”
Another key holding is Washington, D.C.-based CoStar Group Inc., which provides information, analytics and online marketplaces to the commercial real estate sector and related businesses. “We consider CoStar to be a high-quality data services business underpinned by unique data assets and a platform of services that is helping to digitize the real estate industry,” Bowers said.
The fund recently took a position in Oklahoma City-based Paycom Software Inc., a cloud-based payroll and human capital management software provider. “We have always viewed Paycom as a leader in the cloud-native HR solutions space,” Bowers said, adding that “the dislocations in the labour market created by Covid-19 provided an attractive entry point for our investment.”
The Franklin fund also recently initiated a position in Seattle-based Starbucks Corp., the leading global retail coffee brand. “We saw this investment as a high-quality play on the post-Covid global traffic recovery and the ongoing expansion of the Starbucks brand,” Bowers said.
The fund sold off its position in New York-based Peloton Interactive Inc., the at-home fitness platform, in the first quarter. “While we continue to believe that this business is reshaping the fitness industry and will continue to compound its user base, we believe that the stock’s valuation reflected the opportunity ahead of them, at least in the near term,” Bowers said.
The fund also divested its position in San Jose-based Zoom Video Communications Inc. “Though demand remains high and [Zoom’s] service[is] essential, we felt that the valuation more than reflected the growth prospects for the company, particularly when considering peer valuations, the competitive landscape and the impact a Covid-19 vaccine would have on future Zoom usage and revenue,” Bowers said.