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Four Ways You Could Address Your Growth Overweight

November 3, 2020
by Jack Reynolds

Growth Vs. Value Stocks

I have been talking with clients about whether, and if so, how to rebalance away from the US large cap growth overweight inherent in their use of capitalization-weighted (cap-weighted) S&P 500 Index[1] (the Index) focused products. Growth stocks have higher rates of growth in revenue, earnings, and/or cash flow, but may not be cheap. Value stocks are those that appear enticingly inexpensive relative to their earnings and/or assets, but whose growth prospects may not be as robust as the so-called growth stocks.

A potential growth bias arises today because six (of 500) stocks represent about 25% of the Index[2], all of which are well-known growth stocks sometimes known by their acronym the FAANGM’s[3].

Why Might a Growth Bias Concern You?

A question arises whether there is a risk that growth stock valuations are currently unjustifiably high, and whether those prices may correct. Were growth stock prices to deflate, as happened in 2000 when the Tech Bubble burst and in the 1980’s when the price of energy stocks collapsed, it could have an adverse impact on the Index, given the big role of growth stocks in the Index.

By way of historical context, the ten largest stocks in the Index are approaching 30% of its overall value. The last, and only time since 1985, that the top 10 stocks in the Index have exceeded 25% was in early 2000 during the Tech Bubble. In 2016/17 the top 10 stocks in the Index were near a low, of about 17% of the Index (last seen in 1994).[4]

Russell is another provider of US equity market indices.[5] Their large cap US equity index (The Russell 1000) is comprised of 1000 companies. In addition to looking at all 1000 companies, Russell divides the 1000 companies into two pools – one is the growth stocks and the other is the value stocks. One can observe the years in which growth stocks outperform value stock and vice versa.

Reviewing the years 1995 through 2020, there has never been a year where growth outperformed value by as much as in 2020 – growth is ahead of value by roughly 35% this year. That said, in 1998 growth outperformed value by approximately 23%. Again, in 1999 growth outperformed value in the region of 26%. The tables turned in 2000, when value outperformed growth by about 30%. Indeed, value outperformed growth each year 2000 through 2006 – six years in a row. By way of further context, the Russell 1000 Growth has outperformed the Russell 1000 Value for each of the last six years, including 2020 thus far, save one year (2016).[6]

I am compelled to wonder how much longer growth can outperform value without mean reversion reasserting itself. The phrase “this time it is different” can be a dangerous one.

Before considering ways to address a possible overweight to growth stocks, let me clarify what I mean by “cap-weighted S&P 500 Index-focused products.”

  • S&P 500 Index: is a benchmark comprised of the equity securities issued by 500 of the largest companies in America (hence the term large capitalization, or large cap).
  • Capitalization-weighted: or cap-weighted, refers to the fact that by far the most common form of the Index is weighted by each company’s capitalization, which is the share price of the company’s stock multiplied by the number of shares outstanding. Hence, the companies with the greatest market capitalization (or market cap) have a hugely outsized impact on the Index.
  • Product: refers to the fact that one can gain exposure to the Index[7] via an exchange traded fund (ETF), a mutual fund, or a separately managed account approximating the behavior of the Index, or individual stocks that are included in the index.

Four Ways to Ameliorate a Growth Bias

  • Move some, or all, of your cap-weighted S&P 500 exposure to an equal-weighted S&P 500 mandate, which will be inherently less growth-tilted. An equal-weighted S&P 500 Index holds the same 500 stocks, but each stock has the same weighting as every other stock, irrespective of the company’s market cap. The FAANGM’s are roughly 1.2% of the equal-weighted S&P 500 Index, not approximately 25% as with the cap-weighted S&P 500 Index.
  • Move some of your S&P 500 Index exposure to large cap equities in developed countries outside the US, known as EAFE stocks (short for Europe, Asia & the Far East – think: UK, France, Germany, Japan, Australia, and others). These stocks are generally less highly valued than US equities are today. Such a shift would reduce growth exposure and potentially increase a portfolio’s value profile.
  • Engage a US large cap value manager or fund, and/or
  • Employ a US large cap equity manager or fund focused on companies with growing dividends (companies with high static dividends can be “problem children,” so they may be less attractive than dividend growers). The stocks of companies with growing dividends tend to be less hyper growthy than companies without growing dividends. Hyper growth companies tend to retain their profits to fund growth, instead of paying their profits out in dividends. This approach could move a portfolio toward a bit of a value orientation, without investing in troubled companies whose only attractive feature is their high, but static, dividends.

Challenges to Be Considered

  • Asset owners tend to benchmark their equal-weighted S&P 500 Index exposures against the cap-weighted S&P 500 index, which is unrealistic since they are fundamentally different. The whole point of adding the equal-weighted Index exposure is that it will not behave like the cap-weighted Index. Accordingly, advisers typically shy away from recommending equal-weighted S&P 500 Index products for behavioral finance reasons.

The expense ratios associate with equal-weighted S&P 500 funds, while modest by comparison to some actively managed funds[8], are meaningfully higher than those of their cap-weighted peers.[9]

The nature of a cap-weighted index fund is that it needs only to be rebalanced when a company enters or exits the index. Accordingly, turnover is low, which may in turn reduce the tax impact on investors. The nature of an equal-weighted index fund is that it must be rebalanced regularly to maintain the equal weighting of its constituent components as their values rise and fall, increasing turnover.

The smallest components of the equal-weighted index-tracker may give more emphasis to the smallest companies in the index than is appropriate, since their weighting in the index may exaggerate their role in the economy.

Finally, it is interesting to note that none of the three largest providers of index-tracking mutual funds and ETFs[10] offers an equal-weighted S&P 500 Index fund, which may speak to the lack of interest in them by investors.

  • Moving one’s S&P 500 Index exposure to developed country international (EAFE) equities may reduce a portfolio’s growth tilt, but it may also create an unwanted change in the overall portfolio’s geographic profile. One may want to make decisions about geographic exposures separately from decisions about the growth vs. value balance.
  • The decade-long return histories of real value managers, funds, and ETFs are so disappointing that few private investors would take the hard decision to add a new US large cap value manager, fund or ETF right now, though doing so might be wise.
  • If one wants to bring down a portfolio’s growth exposure, might the use of a dividend growth strategy make sense? A review of options such as the following would be a way to start your thinking about this approach.

Examples of Dividend Growth Fund Candidates[11] Might Include:

  • Vanguard Dividend Growth Fund Investor Shares (VDIGX)[12], managed by Wellington for Vanguard, with a 5-star Gold Morningstar rating,
  • J. P. Morgan Equity Income Institutional share class (HLIEX)[13], an actively managed mutual fund with a 5-star Gold Morningstar rating,
  • Vanguard Dividend Appreciation Index Fund Admiral shares (VDADX)[14] Vanguard’s own actively managed mutual fund, with a 5-star Silver Morningstar rating, and
  • Vanguard Dividend Appreciation Index Fund (VIG)[15], an ETF for those preferring a passive approach, with a 4-star Silver Morningstar rating.

Likely, your financial planner, investment advisor, and/or custodian has their own preferences about candidates in the large cap dividend growth space.

See also, The Wall Street Journal’s Dividend Darlings Trail Stock Market Despite Pumped-Up Yields.[16]

Have Questions? 

If and when you consider getting help with any of the foregoing, or to learn more about our Services, please give me a ring at 617 945 5157, or shoot me an Email.

I look forward to hearing from you, and in the meantime stay safe and healthy,
Jack Reynolds

PS, A COVID-19 Suggested Reading

May I suggest the Wall Street Journal’s Tired All the Time? Here Are New Ways to Recharge as the Pandemic Drags On.[17]

 

 


[1] The S&P 500® Index is an unmanaged index of 500 common stocks, most of which are listed on the New York Stock Exchange and other widely recognized stock exchanges in the US. The Index is adjusted for dividends, weighted toward stocks with large market capitalizations, and represents approximately two-thirds of the total market value of all domestic common stocks.

[2] Standard & Poor’s and I/B/E/S or Institutional Brokers’ Estimate System.

[3] Facebook, Amazon, Apple, Netflix, Google/Alphabet, and Microsoft.

[4] Plante Moran Financial Advisers and Morningstar.

[5] The Russell indices are maintained by FTSE Russell, a subsidiary of the London Stock Exchange Group.

[6] Beck, Mack & Oliver LLC, New York, NY, based on Russell Investment Group, LLC data, and Bloomberg, L.P. analytics.

[7] The focus here is on the S&500 Index, but the same can be said of other broad market US large cap indices.

[8] Edgewood Growth Institutional (EGFIX) is a well-regarded US large cap growth equity manager, whose expense ratio is 100 basis points. Vulcan Value Partners Institutional (VVILX) is an example of a US large cap value equity manager, whose expense ratio is 85 basis points.

[9] Invesco S&P 500 Equal Weight ETF’s (RSP’s) fee is 20 basis points, iShares MSCI USA Equal Weighted ETF’s (EUSA’s) fee is 15 basis points. The latter tracks the MSCI USA, rather than the S&P 500, but it is an example of an equal weighted broad market index. On the other hand, Vanguard S&P 500 ETF’s (VOO’s) fee is just 3 basis points. It is a well-regarded cap-weighted S&P 500 Index-tracker with a Morningstar 5-star Gold rating – Morningstar’s highest rating.

[10] iShares by Blackrock, Vanguard, and SPDRs by State Street Global Advisors.

[11] None of the following investment products is recommended by Reynolds Group, Private Investment Counselors, LLC to any individual, family, or institution that is not a client of Reynolds Group. Investment product recommendations can only be made to a specific client in the context of a full and complete understanding of a client well-known to Reynolds Group after due consideration of that specific client’s financial goals, objectives, liquidity requirements, fee sensitivity, and a range of other factors.

[12] Expense ratio 27 basis points.

[13] Expense ratio 74 basis points.

[14] Expense ratio 8 basis points.

[15] Expense ratio 6 basis points.

[16] Subtitled investors fret over the sustainability of big dividend payouts, by Akane Otani and Caitlin McCabe, Oct. 25, 2020 5:30 am ET. In the physical edition of the Wall Street Journal, “Dividend-Rick Stocks Trail Market Despite High Yields,” Oct. 26, 2020, at p. A1, https://www.wsj.com/articles/dividend-darlings-trail-stock-market-despite-pumped-up-yields-11603618202.

[17] By Ellen Byron and illustrations by Jean Tuttle Oct. 25, 2020, 9:00 a.m. Eastern Time, https://www.wsj.com/articles/tired-all-the-time-here-are-new-ways-to-recharge-as-the-pandemic-drags-on-11603630801.