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Growth and Value Stock Indexing Are Both Broken: Nicholas Colas

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The long feud between growth and value equity investors can end. Both concepts are increasingly unhelpful with the shift from active investment to passive portfolios.

As a result of this transition, growth and value are now broken approaches that have the potential to create significant and unnecessary risk for many investors. All-or-nothing methods of index construction create portfolios with dramatic over/under weights in volatile sectors. Single stock weightings can be double more broadly based indexes. Instead of helping investors diversify via traditional “style boxes,” growth and value now herd them into tightly fenced pens.

Growth and value investing came of age during the mutual fund-driven rise of active management in the 1980s and 1990s. As a way for portfolio managers to differentiate and explain their investment styles, they were — and still are — very useful labels. However, as passive indexes — hard-coded rule sets with largely binary stock selection parameters — they have their problems. For example, growth/value classifications create dramatic and potentially risky sector concentrations versus broader market averages.

The S&P 500 Growth Index has a 41.3% weighting to technology. The Russell 1000 Growth Index carries similar exposure, at 39%. At the average of the two, this represents a 60% overweight versus the S&P 500’s 25% exposure to technology stocks.  The S&P 500 Value Index carries only a 7.1% weighting to technology, and instead overweights financials at 25.7%. For the Russell 1000 Value Index, the current weightings are 9.1% technology and 27% financials. The S&P 500 Index has a 15% weighting in financials, so both value indexes show notably incremental concentration. And, of course, technology is essentially a trace element in the S&P 500 Value portfolio.

Growth or value funds also push investors to take noticeably more single-stock risk than broader market averages.

About 27% of the S&P 500 Growth Index is invested in five companies: Apple, Microsoft, Amazon, Facebook and Alphabet. That is almost double their collective weightings in the S&P 500, or 14.3% of total. The story with the Russell 1000 Growth Index is similar, with a 24.7% weight in these names.  On the value side, single stock concentration is actually similar to the S&P 500, with a 13.7% weighting to JPMorgan, Berkshire Hathaway, Exxon Mobil, Bank of America and Johnson & Johnson combined. Still, at a 3.6% weighting in the S&P 500 Value Index, JPMorgan’s influence is almost double what it is in the S&P 500, just to pick one example.

Simply using U.S. small-cap measures such as the Russell 2000 Value or Growth indexes gets rid of the single stock overweight issue, but does little to ameliorate the sector concentration issue.

The Russell 2000 Value Index has a 30% weighting to financials, followed by 12% to industrials and 11% to real estate, most REITs.  The Russell 2000 Growth Index is almost half, or 48%, dedicated to just two sectors: health care at 24% and technology at 24%.

Where all these differences become an important issue is in the world of U.S.-listed exchange-traded funds.

Almost 10% of all ETF assets under management are invested products that track either equity growth or value indexes. Over the last 12 months, investors have added $17 billion of fresh capital into equity growth/value ETFs. That is 13% of all money flows into U.S. stock ETFs, which when compared to the assets under management base in the prior point shows that the popularity of these style-driven approaches is still on the rise.  U.S. equity growth/value ETF assets, which total $340 billion, dwarf the assets of other well-known investment strategies. Dividend/income oriented equity ETFs have $130 billion under management. Emerging equity ETFs have $221 billion of assets. Commodity/precious metals ETFs have $72 billion.

All this means there is a significant amount of equity-market capital invested in indexes that have very concentrated sector and stock holdings. It’s easy to see how this happened. Technology has dominated the growth stock narrative since the financial crisis due to the global nature of the internet and the product innovations that have leveraged that opportunity. Within that powerful investment theme, a handful of names has taken much of the overall economic and capital market gains.

Over the last five years, which have been punctuated by declining volatility, this schism has been largely invisible. Equity ETF investors have actually added more to their value ETF holdings than to growth funds: $45.3 billion of inflows versus $23.9 billion. Given value’s underperformance over the period, that is a genuine testament to contrarian investing.

The recent bout of market volatility has shaken that trend, however. Year-to-date, equity value funds have seen $3.0 billion of outflows while growth funds have enjoyed modest inflows of $286 million. To put those numbers into a greater context, overall U.S. equity inflows totaled $6.1 billion in 2018.

If volatility persists in 2018 — and I believe it will — this recent experience is telling. When you combine marketwide downdrafts with long-term historical underperformance, investors may not treat value stocks as a safer haven than their notionally more volatile growth cousins if market churn persists.

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