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.

Over the past several years, growth investing has easily beaten value. But oddly, growth managers haven’t been able to beat their passive benchmarks during this most favorable time period.

An incredible 86.19% of actively managed mid-cap growth mutual funds lagged the S&P Mid Cap 400 Growth index over the past five years. While that was the worst among all equity style categories, 69.60% of small cap growth funds still underperformed the S&P Small Cap 600 Growth index and 66.67% of large cap growth funds failed to beat the S&P 500 Growth index. Active funds that can’t beat their benchmarks during good times doesn’t instill much confidence they’ll be able to execute that feat during a market downturn.

Another drawback of active management with growth and value investing is the tendency by certain portfolio managers to not strictly adhere to their fund’s mandate. This is particularly true during market extremes. For example, when growth stocks are hot, there’s always the possibility for value managers to chase that hot performance by including growth stocks inside a value oriented portfolio. Although growth stocks may not necessarily meet the strict definition of value, managers might be tempted to bend their own rules by using the “relative value” or “relative growth” logic to skirt the rules.

Portfolio managers complain about being boxed into or limited by the “value” or “growth” label. Is allowing them free rein to be or do whatever they want the answer? Unfortunately, style drift by fund managers creates a hidden portfolio risk to clients by changing the portfolio’s risk character. It also undermines even the most carefully crafted asset allocations, by increasing market exposure to unexpected areas of the equity market. Do clients hire a financial advisor to increase surprises or reduce risk?

Tactical Styles

One investing approach used by advisors is to overweight stocks within a certain style category that are outperforming while simultaneously underweighting the underperformers.

“We have observed a pickup in observed volatility with ETFs that have higher exposure to growth stocks. As a result we have been lowering some exposure to ETFs that exceed our risk limits in some portfolios, said William Ferrell, president & CIO of Ferrell Capital Management. “Value sectors such as consumer staples (XLP), energy (XLE), industrials (XLI) and materials (XLB) have shown low volatility measures and have been give full risk allocations in our portfolios.”

Although growth stocks have outperformed their value counterparts since the 2009 market bottom, that trend is changing.

“Value began to outperform back in early March 2014 as the market began to consolidate and this is probably the next intermediate-term trade (3-6 months),” said Jonathan Beck, chief ETF strategist at J. Beck Investments. “This trend does not tell me much about the market psychology by itself, but the underperformance in one of the growthier sectors of the market, technology, may be a cause for concern if this continues as it represents 18.6% of the market.”

The switch into value stocks away from growth may be signaling a change in the stock market’s mood, as investors rotate from higher beta stocks into more defensive and value oriented companies.

Conclusion

Whether you decide to own growth and value stocks on behalf of clients as a long-term strategy or as tactical positions for a certain market cycle, the ETF universe is a good place to start.

Most growth and value equity ETFs charge annual expense ratios under 0.50% and are a more affordable choice compared to a similar actively managed fund. Also, “pure style” growth and value ETFs are extremely disciplined in the stocks they choose and will generally avoid any hints of style drift.

What investing style you choose will depend greatly on your firm’s investment philosophy and your clients’ goals. Keeping both investing styles in your arsenal will help you adapt in any environment.