VUG - IWY: Strong Choice Despite Growth Rotation Challenges

2024-01-01 19:44:39 ET

Summary

• Growth stocks have made a comeback in 2023 as the macroeconomic environment improves and rates are expected to come down.
• The iShares Russell Top 200 Growth ETF offers reliable exposure to companies with rapid earnings growth and has a consistent record of strong performance.
• While some rotation into value stocks may be beneficial, growth stocks can still amplify returns during market upturns, making IWY a buy.

Thesis

Growth stocks have arguably made a comeback in 2023 after a hurtful rerating in 2022, that left investors heavily geared towards the growth factor facing large losses. As the macroeconomic environment improves and rates are expected to come down, investors are once again optimistic about growth stocks.

In this analysis, I will explore the properties and performance of a rather undiscovered growth ETF, namely iShares Russell Top 200 Growth ETF ( IWY ), while also offering some thoughts around growth vs value positioning going forward.

ETF Overview

The iShares Russell Top 200 Growth ETF tracks the returns of large-capitalization U.S. equities that exhibit growth characteristics, offering investors exposure to companies with earnings that are expected to grow at a more rapid pace compared to the broader market. The ETF is well-diversified, with over 110 holdings, and charges a 0.20% expense ratio (somewhat higher than some competitive funds). Incepted in late 2009, IWY has a consistent record of strong performance, yet it is not considered very popular across the growth ETF universe with approximately $6.5B of net assets.

In terms of allocation across different sectors, IWY is, as expected, geared primarily toward technology stocks (45% weighting), followed by consumer discretionary companies (16% allocation) and communication (13% weighting). IWY, like many other growth funds, is highly cyclical, with over 65% of its allocation entitled towards more aggressive, market-sensitive sectors. As such, the ETF is bound to outperform the market during good times and face large losses during bad ones.

Historical Growth vs. Value Positioning

The value effect has been historically known as the overperformance of stocks that exhibit value characteristics (i.e., low valuation multiples). Over the past 50+ years, the value factor has outperformed, as shown in the chart below.

A prolonged exception to this rule has been the 2014-2022 period when growth stocks saw staggering returns and gained tremendous popularity among investors. As the market rerated in 2022 with rising interest rates, the value effect returned to dominance in 2022. For 2023, however, an improving macro environment has led growth stocks to resurface again.

While the historical value factor overperformance is often attributed to superior fundamentals, interest rates also play a significant role. Periods of rising rates have seen the value effect overstated and the performance gap between value and growth stocks widening. On the other hand, periods of depressed interest rates (like the 2020-2022) have been known to boost the performance of growth stocks.

Growth Prospects Moving Forward

As the market anticipates rates to decline in 2024, with the Fed expected to announce a couple or more cuts, we should naturally expect growth stocks to perform relatively well. However, the stock market is notorious for pricing in anticipated events, and given the run-up of growth stocks in 2023, I believe decreasing rates have already been discounted into current prices.

Moreover, inflation is likely to remain above central banks' targets, negatively affecting discretionary spending, especially in retail, but also regarding input costs for businesses.

While investors have learned over the past 10+ years to rely on growth stocks for outperformance, it may be time to increase their value-factor exposure moving forward. Still, some exposure to growth stocks can be helpful to reap the benefits of potential upcoming bull markets.

Growth ETF Rundown

With growth factor investing becoming increasingly popular over the past decade, in light of strong outperformance, the number of growth-focused ETFs available to investors has significantly increased. Even those that pre-existed for many years have dramatically increased their assets under management and popularity.

Focusing on a few major ETF names that have at least a decade-long track record, an overview of their performance and attributes is provided below. The peer group of growth funds includes besides IWY, the iShares S&P 500 Growth ETF ( IVW ), the Vanguard Growth Index Fund ETF Shares ( VUG ), the iShares Russell 1000 Growth ETF ( IWF ), the Schwab U.S. Large-Cap Growth ETF™ ( SCHG ) and the Vanguard S&P 500 Growth Index Fund ETF Shares ( VOOG ).

Starting off with some downsides for IWY, the ETF charges the highest expense ratio in the peer group, with the lowest being VUG's and SCHG's 0.04%. The 0.16% difference in expense ratio could certainly negatively affect relative returns, especially over a long-term horizon (over a decade-long). IWY is also the smallest fund in terms of AUM, without this being necessarily a downside.

Where IWY shines is in its performance track record, as it has delivered the highest 10Y and 5Y annualized return out of all competitive ETFs, lacking in YTD performance only to SCHG.

IWY's average spread of $0.05 is not discouraging, especially considering that the ETF is much smaller and less known than its peers. However, for someone who would engage in frequent transactions or even ETF trading, IVW is arguably the optimal option.

In terms of valuation and focusing on P/E ratios as they are much more relevant than P/B's in the growth stock universe, IWY appears rather pricey, yet not the most expensive of the peer group. What is evident in the metrics is that the growth factor seems overbought in general. Finally, IWY has the smallest number of holdings, yet still appears well-diversified.

Final Thoughts

After all things are considered, investors who are looking for a more undiscovered ETF in the growth factor space can rely on IWY to target large-cap growth returns for them. Despite its larger-than-average expense ratio, the fund has a strong history of performance, even compared to much more popular ETFs. On a broader portfolio view, even if some rotation into value stocks is probably beneficial going forward, growth can still be present, amplifying returns during market upturns. With these in mind, I would rate IWY as a buy.

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