Growth Stock ETFs

Saturday, August 23, 2008

Growth stocks are well-served by ETFs with four competitive lines of growth stock ETFs. In this report we review recent performance of growth ETFs, strategic and tactical reasons for their use, and how to select between the product lines.

Growth is not known as a haven for troubled times, but ironically it weathered the past year's downturn about twice as well as the overall market:

The graph shows Vanguard's Total Market product VTI trailing all four of its growth ETFs. Similar patterns are found in the other product lines.

What defines growth? In portfolio construction growth typically means emphasizing bonds over stocks to deliver reliable but moderate returns. Here our purpose is asset class selection, and growth refers to companies which grow their earnings at a faster than average rate. Historical growth rates are of interest, but it is price that helps capture all-important future expectations. This is why methodologies to define growth ETFs typically use price/earnings, book value/price (a favorite of researchers) and other price-based financial ratios. Investors pay a higher price per a dollar of earnings, book value, etc. with fast growing companies because they expect the earnings or assets to grow faster.

Why seek out growth? Many investors like growth for the long run because it contains the most dynamic and successful companies. Growth can be a powerful tactical tool, because it often climbs quickly during bull runs. It can also be a contrarian cyclical play, because the longer that value (the opposite of growth) outperforms, the sooner growth is likely to begin to shine again. Together growth vs. value and small vs. large creates a matrix of sub-asset classes, and strategies for overweighting certain ones is called "slice and dice".

Growth has its detractors. More than a decade ago research by Fama and French suggested that growth delivers lower returns at higher risk than value. In particular, small cap growth was pointed out as a particularly unwelcome asset class, both volatile and low performing. No sooner had value been declared champion than growth went on a huge run in the late 1990s. Meanwhile researchers also found that value index performance was not being matched by actual value investor returns because value companies often had closely held stock. Even though growth stocks tanked in 2000, the long-term legitimacy of following growth has been somewhat rehabilitated in the research community.

The four main ETF product lines are based on well-regarded, modern, capitalization-weighted indexes. Vanguard depends on MSCI, SPDR uses Dow Jones Wilshire indexes, while iShares deploys both Russell and S&P indexes. At least a dozen other ETFs not addressed here are based on proprietary enhanced or fundamental indexes.

It is useful that most ETFs in each line are complementary and have no overlap. By sticking to one product line, an investor can overweight one asset class with clarity and precision. Among the exceptions is iShares' IWZ which is a nearly total market product, Vanguard's VUG which is the sum of MGK and VOT (and therefore complementary to remaining VBK), SPDR's EMG which overlaps other Wilshire ETFs in the middle and likewise iShares' IWP.

The main difference between the lines is how far they reach into small-sized companies. In this table we present the range of company size each one targets and their fees:

  • iShares Russell 1000 Growth ETF (NYSEArca:IWF): 1000 largest firms, .20%/year fees
  • iShares Russell 2000 Growth ETF (NYSEArca:IWO): 1001-2000 largest firms, .25%
  • iShares Russell 3000 Growth ETF (NYSEArca:IWZ): 3000 largest firms, .25%
  • iShares Russell Midcap Growth ETF (NYSEArca:IWP): 201-1000 largest firms., .25%
  • iShares S&P 500 Growth ETF (NYSEArca:IVW): 500 largest firms, .18%
  • iShares S&P MidCap 400 Growth ETF (NYSEArca:IJK): 501 to 900 largest, .25%
  • iShares S&P SmallCap 600 Growth ETF (NYSEArca:IJK): 901 to 1500 largest, .25%
  • SPDR Dow Jones Wilshire Large Cap Growth ETF (AMEX:ELG): largest 750, .20%
  • SPDR Dow Jones Wilshire Mid Cap Growth ETF (AMEX:EMG): 501-1000 largest, .25%
  • SPDR Dow Jones Wilshire Small Cap Growth ETF (AMEX:DSG): 751-2500 largest, .25%
  • Vanguard Growth ETF (AMEX:VUG): 750 largest firms, .11%
  • Vanguard Mega Cap 300 Growth ETF (NYSEArca:MGK): 300 largest firms, .13%
  • Vanguard Mid-Cap Growth ETF (AMEX:VOT): 301-750 largest firms, .13%
  • Vanguard Small-Cap Growth ETF (AMEX:VBK): 751-1750 largest, .12%

It is important to note that each ETF holds only about half of the companies in its target range. For instance, IJK sifts through the 500 largest US companies to come up with about 250 growth firms which it actually buys.

All the products have reasonable fees and thoughtful indexes. Probably the largest differentiator is the range of company range. Growth investors who wish to overweight (now or at a later date) a range of certain sized companies should find an ETF that matches that range. An important question is how much each ETF in a product line replicates the total underlying market. The top 500 US companies, for instance, comprise about 80% of value of all publicly traded stocks. To overweight large cap one must allocate more than 80% of funds dedicated for the growth strategy, and to underweight one must allocate less. Unfortunately up-to-date figures for what would constitute market neutral weighting within a product line are not made clear by many providers.

Another differentiator is cost, where Vanguard as usual holds a small lead. For the investor who is unsure or may change their mind on what sized companies to target, this is the logical default choice.

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.