ILCG - ILCG: Growth Equities Fund Getting Stretched

2023-07-11 04:33:50 ET

Summary

• The iShares Morningstar Growth ETF, which focuses on large and mid-cap growth equities, has seen a strong performance in 2023.
• The ETF's performance is largely driven by tech mega-caps, with its portfolio showing stretched valuation metrics; it is up 26% this year, representing a midpoint between QQQ's 37% performance and VOT's 13% gain.
• The fund follows a proprietary Morningstar index that represents a blend of Mid-Cap and Large-Cap Growth names.
• The portfolio holdings exhibit stretched valuation metrics, with average P/E ratios in the high 20s despite the substantial increase in risk-free rates.

Thesis

The iShares Morningstar Growth ETF ( ILCG ) is an equities exchange traded fund. The vehicle focuses on large and mid-cap growth equities, and has had a parabolic performance in 2023, closely tracking the Nasdaq. It has been an unexpected ride for growth equities on the back of higher rates. Most market participants were expecting a heavy sell-off in Q1, but it never materialized. Instead we got a huge market rally, in part driven by heavy short covering.

It is interesting to notice how the markets work. Fear and greed are the main drivers here, and investors expect to make money both during an up and a down market. Down markets are harder to trade, but in a down market investors looking to profit usually short-sell stocks. There is a cost component to short-selling (the cost of borrowing the stock from the brokerage house) as well as a psychological cost. A short seller technically has unlimited downside since stocks can go as high as they choose to. Point in case is the recent rally in Carvana ( CVNA ), one of the stocks with the highest short percentage out there:

Aside from the astounding 521% rally, do note the vertical 'gap-up' moves. Those are short seller driven - more precisely people covering their short positions. While fundamentally problematic CVNA is a poster child for the 2023 market - fund flows and short covering drive short term momentum.

In this article we are going to have a look at ILCG, its composition, its performance drivers and expectations for future performance when compared to simple index funds.

Morningstar US Large-Mid Cap Broad Growth Index

The iShares Morningstar Growth ETF aims to track a proprietary Morningstar Index, namely the Morningstar US Large-Mid Cap Broad Growth Index. The Index builds its portfolio following a rules-based approach in identifying stocks falling in the Morningstar Mid/Large Growth buckets:

All eligible stocks are assigned a composite value/growth style score, based on 10 distinct historical and forward-looking variables (five for value and five for growth). Value and growth scores are combined so that each accounts for one half of a stock's final style score. Stocks are then assigned to pure growth, pure value, or a blend based on the relative strength of their style score. Each group comprises roughly one third of the market capitalization within its respective size segment. Pure value and pure growth stocks are fully allocated to their respective style indexes. Stocks that fall in the middle of the value/growth spectrum are partially allocated to both the value and growth indexes.

As with any rules based index, ultimately its performance versus simple indices matter. Most proprietary indices fail to capture any beta in the markets and end up posting underwhelming performances versus vanilla instruments.

ETF Composition

The fund currently holds 452 names, overweight information technology:

The top holdings are very familiar tech mega-caps, which are broadly held in both the Nasdaq and the S&P 500:

The underlying index is market weighted, and so is the ETF. The top 10 names account for over 43% of the portfolio, with the rest of the 442 remaining names having a much lower proportion. Given this feature and the outperformance of mega-caps this year, it is not surprising to see the fund post an astounding performance in 2023:

Please note that the Invesco QQQ Trust ( QQQ ) represents Large-Cap Growth, while the Vanguard Mid-Cap Growth ETF ( VOT ) represents a pure mid-cap growth portfolio performance. ILCG falls straight in the middle of the two from a performance stand-point, representing an almost perfect arithmetic average. It is very much akin to a 50% QQQ / 50% VOT portfolio allocation.

Long term, the relationship holds:

We can see that on a 5-year look-back QQQ produces a 106% return, while VOT produced a 47% price return. The average of these two is 76.5%, which is extremely close to what ILCG posted. From a visual stand-point, the fund represents an average of the following Morningstar boxes:

Valuation and Forward

It should not come as a surprise to an informed reader that P/E ratios in the Growth bucket are back up to astounding levels:

While high P/E ratios might be tolerable in a 0% rates environment, in our mind 5% risk free rates should discount to different PV levels. The numbers here are skewed because of the mega-tech names, with pure mid-caps in the growth bucket having P/E figures in the low 20s.

We are of the opinion that entry points matter, and in order to have long term robust returns, an investor needs a good starting P/E level. High 20s for this fund is expensive, not cheap.

We are also of the opinion that we will have a significant risk-off event in the second half of this year, which will present nice entry points into this fund.

Conclusion

The iShares Morningstar Growth ETF is an equities exchange traded fund. The vehicle aims to replicate the total return profile of the Morningstar US Large-Mid Cap Broad Growth Index . The index straddles the mid-cap and large-cap growth buckets in the Morningstar box, and it is market weighted. ILCG has a historic price performance which is very similar to a 50% QQQ / 50% VOT portfolio allocation. The ETF is up 26% this year, representing a midpoint between QQQ's astounding 37% performance and VOT's 13% gain. Gains this year have been mainly driven by tech mega-caps, and ILCG's portfolio shows stretched valuation metrics.

Despite the astounding rally in 2023, we do not believe we are witnessing a new cyclical bull market, and expect a risk-off event in the second half of the year as rates keep climbing. If you own ILCG then crystalize some of the gains and de-risk, expecting much better entry points later in the year.

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