The benefits of US equities can’t be ignored

Australians tend to concentrate investments and wealth within our borders. Whether it be in the property market or domestic equities, structural benefits such as negative gearing and franking credits make local assets hard to resist.

Danielle Ecuyer has over three decades of experience in equity markets, holding senior positions in institutional equities and wealth management in the UK and Australia. Since 2008, she has managed her own investments and distilled her learnings into two books. Her second book takes a deep dive into how to invest in the US stock markets, as a result of her decision to sell most of her banking shares.

I sat down with Danielle to discuss her thesis for the US, how it differs from Australian investments and what Aussie investors should be aware of. I have reflected her views throughout this piece and included Morningstar’s ETF pick for US exposure at the end of this article.

Selling the banks

Danielle recalls her decision to sell her bank shares as straight forward. Australian banking shares had been very strong in the run up to May 2015, with investors seeking out yield considering the decline in interest rates.

The driver of this decision was concerns about her concentration to banks which are intrinsically linked to housing and property in Australia. Many Australians are wary about the concentrated exposure to financials and resources in Australia’s 200 largest companies. However, not many of us do much about it apart from doubling down.

However, this concentration risk was exacerbated by owning her home outright. She felt that her exposure to real estate was too high when taking a holistic view of her finances.

As this was happening, the economic outlook was also fading. It did not translate to a positive outlook for the banks. Danielle wanted to add more growth and fewer cyclical companies and turned to the US to do so.

Danielle was attracted to the US markets due to the size and liquidity – it is the largest listed equity market in the world by a long shot with US$300 billion flowing through it each day. It was a considered decision to diversify portfolio risk by industry and region while adding depth to the diversification through currency exposure.

Fast forward to today and Danielle sits on a US portfolio that is larger than her Australian share portfolio. This has been due to the outperformance of her US investments since 2015 and the currency gains from a weaker Australian dollar. Her portfolio is tilted towards secular growth companies that aren’t as plentiful in the narrower Aussie market. Her holdings are across healthcare, bio-techs, big tech and longer-term dividend compounders. The underlying theme across all her holdings is quality.

She does not hedge currency to add a further level of diversification and has integrated the currency exposure into her investment strategy.

What does the US have that Australia doesn’t?

Danielle’s second book declares that her one-word rationale to investing in US stocks is ‘innovation’.

She believes that Australia continues to be the lucky country, blessed with natural resources and a booming housing market, thanks to the long-standing immigration policies which underwrite population growth and demand for property. We’re all familiar with how this has been a large contributor to the wealth of this country and the prosperity of its people.
The US is also a world leader in commodities and property. The difference is that for the last 120 years, American companies have also been innovators.

The US has a starkly different culture around failure which fosters innovation. Failure associated with innovation is celebrated. Widespread support of profit generating capitalism is at the origin of modern American culture. This approach to capitalism and a reflexive desire for small government was established as a pushback against the more liberal, worker/union orientated European and British economies and establishments. There are many critics of this style of capitalism, but there is no denying that it is a culture that fosters and catalyses innovation.

Illustrative of this point are the journeys of the latest round of billionaires. The road to success for Elon Musk, Jeff Bezos and Bill Gates was paved with near catastrophic failures. It is in this same spirit that investors are more than happy to back start-ups.

Recent Australian governments have recognised the importance of innovation in the success of US companies. There have been large efforts to invest in innovation and the start-up economy to foster this same culture. The investment has been welcome but has largely been unsuccessful at changing the culture around failure.

We’re not the same as our cousins across the Pacific.

Danielle notes that there are a few differences that Australians investing in the US may notice in comparison to the domestic market. to investing domestically.

She calls out that the most notable difference is the dividend payments in terms of yield and franking. Australian companies have some of the highest dividend payout rates in the world which has led to a relatively high dividend yield for most large cap ASX listed companies.

Franking credits were designed to avoid double taxation for shareholders and are a pivotal part of many local investment strategies. The downside of high yielding shares is opportunity cost. It means that they can evolve into capital killers over time – focusing too much on keeping shareholders happy with dividends that offer instant gratification, and not investing enough in the growth of the business.

When you look at the US markets in comparison, they have evolved to pay lower dividends due to a preference for share buybacks. Danielle calls out that this is not a perfect system either. However, on balance, quality dividend growers in the US yield around 2%, vs. the domestic banks at 4%+ pre-franking.

Capital is finite. The problem for Australian companies is that when there is so much emphasis placed on paying out dividends to shareholders, they often to not have the excess capital for sufficient research and development, or to invest for the future.

No one approach is superior to the other. It is up to investors to understand whether one, or both of these approaches fit in with their investment strategy to achieve their financial goals. For Danielle, growth is an important part of her strategy and how she views quality investments over the long-term.

If you invest in the US, how involved do you need to be?

Like Aussie investments, the market contains options that appeal to all types of investors. Danielle calls out that investors can be as involved or uninvolved as they are with their domestic holdings.

Danielle loves the intellectual aspect of investing. She has a keen interest in absorbing as much as she can on megatrends/secular trends like AI and green energy. This means that she takes a keen interest in stock picking.

At the same time, investors can access US markets through a passive ETF that provides exposure to the US markets.

Danielle urges investors to look at more than just dividend yields and franking credits. She says that investors should consider investing in US shares in the context of total return – income and capital return.

High yielding and cheap stocks can be value traps, meaning investors pick up a relatively high income but lose capital over time. She points to Westpac as an example. The share price remains below the 2015 high. Yes, investors have generated income but at what cost?
Recently the US market has provided a much higher capital return. Looking at P/E (Price to Earnings), the S&P500 is more expensive than the ASX/200, but Danielle reiterates that cheap does not always mean good. Low P/E doesn’t guarantee good shareholder returns.
Where does US exposure fit into investors’ portfolios, if at all?

Home bias is the tendency to stick with what feels comfortable. It means personal experiences and allegiances play an outsized role in the decisions we make. Home bias is why people gravitate to the same brands at the store, why people bet more on their favourite sports teams and why people invest in local companies.

We can see from the 2023 ASX Investor Study that we have a strong preference for Aussie shares and property. As mentioned, there are tax advantages that contribute to the total return that investors receive, and there is a propensity for higher yields with Australian shares. Many investors find this attractive.

There aren’t many investment professionals out there that would suggest that your portfolio should only be allocated to its equivalent size in the global market. However, it is important to acknowledge the concentration risk that we bring into our portfolios.

The primary benefit you gain is choice when investing internationally. Australia is extremely concentrated in a few industries. Different industries will perform differently depending upon the market and economic environment. This is important when you are creating a diversified, long-term portfolio.

Danielle takes a more holistic approach to her wealth which extends beyond the investments held in her portfolio. Working and living in a country the local economy plays a large role in determining financial well-being. A downturn in the local economy can lead to (or be caused by) depressed prices in housing and the share market. At the same time, your livelihood could suffer as economic upheaval often leads to wage cuts and job losses. If you’re on the eve of retirement it could dramatically alter your future prospects.

This effect may be amplified for a country like Australia that makes up a smaller percentage of the global economy. We learned this lesson during the 2008 Global Financial Crisis (GFC). The Aussie stock market is not immune to economic shocks on the other side of the world. The local economy held up well and Australia avoided a recession. At the same time, it’s important to remember that the Australian stock market still experienced similar losses to the US, which was the epicentre of the crisis.

On the other side of the coin, it is hard to imagine a homegrown recession in Australia—caused by, for example, a slump in housing or commodity prices—making much of an impact on major markets in North America, Europe or Asia.

Get back to the fundamentals of investing. Buying a share is taking ownership in a company and the value of owning a company is the future profits that a company will generate. When you diversify internationally, it diversifies the revenue streams and the profits of the companies that we own.

Danielle believes that asset allocation is very personal. Any decision must weigh the risks of to the USD exchange rate and consider what the investor is seeking to achieve and the length of the investing time frame.

US markets have substantially outperformed over the last 10-years. Investors need to appreciate what companies they are buying and for what reasons. The US mega tech companies represent almost 40% of the Nasdaq 100 index and 25% of the S&P500 index. They are secular long term growth giants that suit the needs of Danielle’s investment strategy and financial goals.

Danielle concludes that the exposure to the US depends on your individual circumstances. In saying this she believes that there is an opportunity cost in not having exposure to the US markets.

Morningstar’s choice for US ETF equity exposure

I recently wrote on the three largest ETFs in Australia. Danielle is not the only Australian that is increasing their portfolio exposure to the US. Their vehicle of choice is iShares S&P 500 ETF IVV, the third largest ETF, behind Vanguard Australian Shares VAS and Dimensional Core Global Equity Trust DGCE.

Given the breadth of coverage and the cost efficiency, iShares S&P 500 ETF IVV is a fine choice for investors seeking US-specific equity exposure. It is awarded a gold medalist rating from our manager research team. The strategy is expected to outperform its peers over the long term and remains the clear choice for investors to gain US exposure. It can be paired with other ex-US products to form a balanced global equity portfolio.

The underlying benchmark, the S&P 500, is a market-cap-weighted index of the largest 500 companies in the United States. Thus, it offers giant- to mid-cap exposure, covering about 80% of the free-float-adjusted market cap of the US equity market. This results in a well-diversified index at the stock and sector levels. As such, passive strategies that track the S&P 500 stand as above-average options in a market segment where active managers have generally struggled to outperform. Consisting of highly liquid stocks, material stock-specific valuation information is quickly incorporated into stock prices.

From an Australian perspective, IVV gives exposure to a broad portfolio of some of the world’s most noteworthy companies, including sectors that are underrepresented in Australia such as technology and healthcare. The S&P 500’s correlation to Australian equities has come down in recent years, effectively adding to diversification for Australian equities exposure. It earns a silver medalist rating.

At an annual fee of 0.04%, the fund is priced attractively compared to active and passive peers.

When we look to the index’s exposure, 51% of the index is in the top 10 holdings, over 7% of the index is in one holding – Microsoft MSFT, 6.75% in another – Apple AAPL. The index is highly concentrated in tech, with almost 30% of the index in this sector (at 12 January 2024).