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May 27, 2014 at 08:00 PM
Like the two roommates in the “Odd Couple” sitcom, growth and value investors are polar opposites. The growth camp wants to own stocks with fast-growing sales and earnings, regardless of valuation. The value camp wants to own companies with low price-to-earnings ratios and dividends. Neither group agrees about the competing group’s investment strategy.
Although studies have suggested that value investors win out over the long run, there is a definite place for both investing styles. Even though value investors point to Warren Buffett as their proof of success, growth stocks have recently outperformed. For financial advisors, each investing style is offered via ETFs in a convenient and affordable package. Let’s examine ETFs tracking each style.
Varying Definitions
Large index providers like MSCI, Russell, Standard & Poor’s and Morningstar each have their own criteria for defining and separating growth and value stocks from each other. It behooves advisors to understand the differences.
Russell, for instance, uses price-to-book and earnings growth to determine value stocks versus growth. Stocks with high price-to-book ratios are classified as growth, whereas stocks with low price-to-book are categorized as value. What about the stocks in the middle?
Russell takes equities in the middle ground and categorizes them as both value and growth, which means stocks get included in both types of indexes. For example, Apple and Wal-Mart are holdings in both the iShares Russell 1000 Growth ETF (IWF) and the iShares Russell 1000 Value ETF (LCV) because both stocks have value and growth characteristics, according to Russell’s classification system. MSCI takes a similar approach, adding other financial factors to the mix.
Style-based ETFs that include value stocks inside a growth index and growth stocks inside a value index are subtle details that advisors who don’t look beyond a fund’s label may miss. It may also create a subtle form of unwanted style drift.
“When the growth bubble burst in 2007 the price-to-book of financial stocks got crushed and Russell categorized them as deep value stocks largely because the book value stayed the same,” observes Ron Surz, president of consulting firm PPCA.”I was calling those fallen financials growth stocks because the actual earnings tanked even more than price. For that reason, the P/E ratio is much more reflective of what the current situation is with a company’s stock.”
Stricter Approach
The Guggenheim S&P Pure Style ETFs aim to remove the overlap between growth and value by making sure growth stocks don’t end up inside a value index and vice versa. By purposely excluding stocks with both growth and value characteristics, the indexes are “pure style.” What screening factors are used?
Growth stocks in the underlying S&P Pure Style Indexes are screened for sales growth, earnings growth and price momentum. Thereafter they’re ranked and weighted by those growth characteristics in the Guggenheim S&P 500 Pure Growth ETF (RPG), Guggenheim S&P Mid Cap 500 Pure Growth ETF (RFG) and Guggenheim S&P Small Cap 600 Pure Growth ETF (RZG).
For value stocks, S&P uses price-to-book, sales-to-price and P/E ratios to select stocks in the Guggenheim S&P 500 Pure Value ETF (RPV), Guggenheim S&P Mid Cap 500 Pure Value ETF (RFV) and Guggenheim S&P Small Cap 600 Pure Value ETF (RZVG).
The chief goal of “pure style” indexes is for the stocks within each type of index (growth or value) to be a truer representation of that particular investment style.
Active Management
What about choosing funds managed by top growth or top value portfolio managers? Unfortunately, great historical performance doesn’t tell advisors much about the future and choosing funds upon this basis may actually result in subpar performance.
