Tortoise or Hare? Growth ETFs Gain Ground

By Jonathan Bernstein,

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Growth ETFs are funds that hold high-growth companies. High growth companies prioritize speedy revenue growth and earnings growth over regular and reliable dividend payments to shareholders. The thinking is that growth companies that retain and invest their earnings will do better over the longer term than companies who pay out those earnings to shareholders.

How have growth ETFs performed recently? The chart below compares the performance of growth to value. The iShares Russell Growth Index ( IWF )is a fund that prioritizes earnings growth. The iShares Russell 1000 Value Index ( IWD ) is a value fund which prioritizes dividends.

Growth is winning. IWF is beating IWD. As the chart shows, the two traded fairly closely through October 2010, when growth fund IWF pulled ahead. This timing is not coincidental. In October a stronger market began to ameliorate investor concern about the continued growth of the domestic economy.

One way to measure investor concern about market direction is the movement volatility index or VIX, which tracks the price of options on the ubiquitous S&P 500 Index. Investors use put options on the S&P 500 Index to protect against losses. If these options are expensive this suggests that investors are willing to pay up to protect portfolios. The chart below shows the iPath S&P 500 VIX Mid-Term Futures ETN ( VXZ ), which tracks the VIX.

The chart shows that the VIX see-sawed through September. Looking at the chart, in October, the VXZ, proxy for the VIX, registered a discernable direction of decline. This coincides roughly to the time when growth began to outperform value. The outperformance of IWF and the decline in the VIX reflects investors then new resolve to shake off worry of a double-dip recession. In November the Federal Reserve announced its bond buying program, known as QE2. The trend reinforced and strengthened.

Growth ETFs tend to be higher beta than value funds. This means that in strong markets they typically outperform the benchmark. In weaker markets they tend to underperform. Growth is outperforming value across market capitalization. The chart below compares the returns of a smaller cap growth fund, iShares Russell 3000 Growth ETF (NYSEArca:IWZ) with a smaller cap value fund, iShares Russell 3000 Value ETF (NYSEArca:IWW)

Although strong earnings are important to classifying a company as a growth stock and dividends are important to classifying a company as a value, there are no strict definitions. An individual company can be expressed as either a growth or a value stock. Holdings in growth and value funds overlap. Oil major Exxon Mobile (NYSEArca:XOM) for example is the largest holding in both IWF and IWD shown in the first chart above.

Growth ETFs tend to have more exposure to the technology sector, less to industrials and financials. Historically, strong technology performance is another predictor of the relative strength of growth funds. In the 1990s technology outperformed the broad market. Growth beat value. At the height of the tech bubble, the P/E ratios of growth funds were twice that of value funds. Over the last decade, the PE ratio of technology companies contracted. Value outperformed growth.

A general slowdown in the U.S. equity markets over the past decade and the trend to lower interest rates has helped value to outperform. Growth ETFs typically pay lower dividends (IWD's dividend is currently 50% higher than IWF). Although this amounts to about 100 basis points, the certainty counts. In a slow growth environment of low interest rates, every basis point counts.

The stubborn underperformance of growth over the last decade recalls research by Fama and French published in the mid 1990s. In a famous study Fama and French panned growth stocks. They suggested that growth over the longer term delivers lower returns at higher risk than value funds. (They also singled out small cap growth as an especially unwelcome asset class, both volatile and low performing.) Ironically, no sooner than they finished their study, growth stocks when on an extended run, far outperforming value.

There a many types of growth ETFs, including fundamental funds, leverage funds and short ETFs that are useful for traders. The plain vanilla growth funds are differentiated primarily in terms of the market cap size of their holdings and their exposure to small companies. Growth investors who wish to overweight a range of certain sized growth companies should find an ETF that matches that range. The list below presents traditional growth ETFs, the company size targeted in their holdings, as well as their fees:

Traditional "Plain Vanilla" Growth ETFs

iShares Russell 1000 Growth ETF (NYSEArca:IWF): 1000 largest firms, 0.20%

iShares Russell 2000 Growth ETF (NYSEArca:IWO): 1001-2000 largest firms, 0.25%

iShares Russell 3000 Growth ETF (NYSEArca:IWZ): 3000 largest firms, 0.25%

iShares Russell Midcap Growth ETF (NYSEArca:IWP): 201-1000 largest firms., 0.25%

iShares S&P 500 Growth ETF (NYSEArca:IVW): 500 largest firms, 0.18%

iShares S&P MidCap 400 Growth ETF (NYSEArca:IJK): 501 to 900 largest, 0.25%

iShares S&P SmallCap 600 Growth Index Fund ( IJT ): 901 to 1500 largest, 0.25%

SPDR Dow Jones Wilshire Large Cap Growth ETF (NYSEArca:SPYG): largest 500, 0.20%

SPDR Dow Jones Wilshire Mid Cap Growth ETF (NYSEArca:MDYG): 501-1000 largest, 0.25%

SPDR S&P 600 Small Cap Growth ETF (NYSEArac:SLYG): 751-2500 largest, 0.25%

Vanguard Growth ETF (NYSEArca:VUG): 750 largest firms, 0.12%

Vanguard Mega Cap 300 Growth ETF (NYSEArca:MGK): 300 largest firms, 0.13%

Vanguard Mid-Cap Growth ETF (NYSEArca:VOT): 301-750 largest firms, 0.13%

Vanguard Small-Cap Growth ETF ( VBK ): 751-1750 largest, 0.12%

Rydex S&P 500 Pure Growth ETF (NYSEArca:RPG), 500 largest firms, 0.35%

Rydex S&P MidCap 400 Pure Growth ETF (NYSEArca:RFG), 501-900 largest, 0.35%

Rydex S&P SmallCap 600 Pure Growth ETF (NYSEArca:RZG), 901-1500 largest, 0.35%

iShares Morningstar Large Growth Index Fund (NYSEArca:JKE), 0.25%

iShares Morningstar Mid Growth Index Fund (NYSEArca:JKH), 0.30%

iShares Morningstar Small Growth Index Fund (NYSEArca:JKK), 0.30%

PowerShares Autonomic Balanced Growth NFA Global Asset Portfolio ETF (NYSEArca:PAO), 0.25%

PowerShares Autonomic Growth NFA Global Asset Portfolio ETF (NYSEArca:PTO), 0.25%

Fundamental Growth ETFs

There are also several ETFs based on proprietary enhanced or fundamental indexes. Fees are higher.

First Trust Large Cap Growth Opportunities AlphaDEX Fund (NYSEArca:FTC), 0.7%

Powershares Dynamic Large Cap Growth Portfolio ETF (NYSEArca:PWB), 0.61%

Powershares Dynamic Mid Cap Growth Portfolio ETF (NYSEArca:PWJ), 0.63%

Powershares Dynamic Small Cap Growth Portfolio ETF (NYSEArca:PWT), 0.63%

And finally, short and leverage growth ETFs suitable for speculative traders looking for a short-term play:

Short/Leverage Growth ETFs

ProShares Ultra Russell 1000 Growth ETF (NYSEArca:UKF), 0.95%

ProShares Ultra Russell 2000 Growth ETF (NYSEArca:UKK), 0.95%

ProShares Ultra Russell MidCap Growth ETF (NYSEArca:UKW), 0.95%

ProShares UltraShort Russell 1000 Growth ETF (NYSEArca:SFK), 0.95%

ProShares UltraShort Russell 2000 Growth ETF (NYSEArca:SKK), 0.95%

ProShares UltraShort Russell MidCap Growth ETF (NYSEArca:SDK), 0.95%

Jonathan Bernstein has been writing about ETFs since 2003 and is the author of Sector Trading: A Year in Exchange Traded Funds .

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

This article appears in: Investing ETFs
Referenced Stocks: IJT , IWD , IWF , VBK , VXZ

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