VUG - RPG: Pure Growth Potential Without Mega Caps But Does It Deliver?

2023-10-19 14:35:00 ET

Summary

• Invesco S&P 500® Pure Growth ETF tracks the S&P 500 Pure Growth Index, selecting 80 large-cap stocks with the strongest growth characteristics. Fees are 0.35% and the ETF has $1.80 billion in assets under management.
• Surprisingly, the RPG ETF has underperformed plain vanilla market-cap-weighted funds like Vanguard Growth Index Fund ETF Shares in years when growth stocks outperformed value stocks. Therefore, it's not appropriate for aggressive growth investors.
• With reconstitutions occurring just once per year, style drift could occur. Today, RPG features less estimated sales and earnings growth than the Vanguard Growth ETF, and is 30% Energy.
• As a result, RPG acts best as an inflation protector, and growth investors should at least wait until the next reconstitution in December before considering an investment.

Investment Thesis

The Invesco S&P 500® Pure Growth ETF ( RPG ) has barely broken even this year, a surprising find in a year where most growth exchange-traded funds ("ETFs") have substantially exceeded expectations. After evaluating its composition, the reason is clear. RPG has nearly zero allocation to the "Magnificent Seven" stocks responsible for 70% of the market's returns in 2023.

Avoiding these companies is not prudent, as they are highly profitable and have proven resilient over the long run. That doesn't mean investors should ignore valuations, but when a fund like RPG doesn't even offer superior earnings growth over plain vanilla options like the Vanguard Growth Index Fund ETF Shares ( VUG ), it's a red flag. That's the case today and why I recommend readers avoid this high-risk, energy-dependent ETF.

RPG Overview

Strategy Discussion: Style Scores And Style Drift

RPG tracks the S&P 500 Pure Growth Index, selecting 80 S&P 500 (SP500) securities with the strongest growth characteristics. The process begins with assigning style scores to each security. The value style score is based on book-value-to-price, earnings-to-price, and sales-to-price ratios. The growth style score is based on three-year sales per share growth, the three-year ratio of earnings per share change to price per share, and the twelve-month percentage change in share price.

Unlike the S&P 500 Growth Index, the S&P 500 Pure Growth Index only selects deep-growth stocks. Importantly, there is no overlap with the S&P 500 Pure Value Index, so it offers investors an easy way to differentiate between pure growth and pure value. The downside is there is no "middle ground." Furthermore, since style scores are only calculated once annually and are based on historical data, there is a strong potential for style drift.

In other words, what was once a pure growth stock could become a pure value stock as the year progresses. We're in October, more than ten months after the Index last reconstituted. Oil & Gas E&P stocks, which represent 20% of the portfolio, are no longer in favor. To illustrate, after delivering a 57.26% gain in 2022, the iShares U.S. Oil & Gas Exploration & Production ETF ( IEO ) is up just 11.55% year-to-date, with virtually all those gains occurring in July. For this reason alone, investors may want to wait until after the Index reconstitutes in late December before considering an investment.

Sector Exposures and Top Ten Holdings

As of October 17, 2023, RPG has 29.57% exposure to the Energy sector, followed by Healthcare and Technology at 19.25% and 14.94%, respectively. The concentration is high, but that's what you often get with pure growth funds. That said, it's not necessarily less diversified than VUG, which has 43.18% exposure to Technology stocks.

RPG's top ten holdings are listed below, totaling 24.13% of the portfolio. As mentioned, Oil & Gas E&P stocks like Diamondback Energy ( FANG ) and Coterra Energy ( CTRA ) are prominent. There are also several Biotechnology companies like Vertex Pharmaceuticals ( VRTX ) and Regeneron Pharmaceuticals ( REGN ), and some Steel stocks like Steel Dynamics ( STLD ) and Nucor ( NUE ).

Except for APA Corporation ( APA ), all these holdings are up on the year, which is how they've floated to the top of the list. However, it's essential to look at the rest of the portfolio and avoid getting caught up analyzing only the fund's top holdings. For example, RPG's bottom ten holdings are down 36.95% on average this year, and the average holding is up just 5.00%.

In addition, it matters what is not included. As mentioned, the Magnificent Seven has delivered more than 70% of the market's gains in 2023. The seven stocks are as follows:

• Apple ( AAPL ): 36.84%.
• Microsoft ( MSFT ): 38.46%.
• Alphabet (GOOG) ( GOOGL ): 58.36%.
• Amazon ( AMZN ): 56.51%.
• Nvidia ( NVDA ): 200.66%.
• Meta Platforms ( META ): 169.24%.
• Tesla ( TSLA ): 106.89%.

These stocks total 49.66% of VUG's weight but only 1.22% in RPG, which is entirely Apple. The math is impossible for RPG to be a successful investment in 2023, at least relative to VUG.

Performance Analysis

RPG Performance In Growth-Favored Markets

The following chart highlights annual returns for RPG, VUG, and the Vanguard Value Index Fund ETF Shares ( VTV ), a proxy for large-cap value stocks.

There were six years when VUG outperformed VTV by at least 5%, as follows:

• 2007: 12.62% (12.52% vs. -0.11%).
• 2009: 16.27% (36.13% vs. 19.86%).
• 2017: 10.58% (27.72% vs. 17.14%).
• 2019: 11.38% (37.03% vs. 25.65%).
• 2020: 37.96% (40.22% vs. 2.26%).
• 2023: 31.34% (32.30% vs. 0.96%).

Except for 2007, these were excellent years for growth stocks. It's reasonable to assume that "pure growth" stocks would perform even better these years, but that hasn't been the case. Only in 2009 did RPG outperform VUG (49.35% vs. 36.13%). The remaining five years saw RPG lag by 11.12% on average. In short, if you're an aggressive growth investor, don't assume a pure growth fund will outperform in growth-favored markets.

RPG Performance Since Inception

The following table highlights RPG's cumulative returns since its March 2006 launch. I've assigned VUG and the SPDR® Portfolio S&P 500 Growth ETF ( SPYG ) as market-cap-weighted benchmarks.

RPG has delivered a 9.57% annualized return over the last 17 years, 1.34% and 1.11% lower than VUG and SPYG. It was also more volatile, as measured by the annualized standard deviation of monthly returns, and had a slightly worse maximum drawdown of 48.92% during the Great Financial Crisis between November 2007 and February 2009. These results led to worse risk-adjusted returns (Sharpe and Sortino Ratios).

Also, consider the table below of periodic total returns and total risk-adjusted returns for RPG, VUG, SPYG, and the Vanguard Mega Cap Growth ETF ( MGK ). I've highlighted MGK to demonstrate how well mega-cap growth stocks have outperformed over the last decade.

Note how, except for the last three months, there is not a single period where RPG outperformed these peers on these metrics. You may be attracted to RPG because it doesn't hold many mega-caps, but avoiding them entirely, as RPG primarily does, has not been a winning strategy.

RPG Fundamentals

The following table highlights selected fundamental metrics for RPG's top 25 sub-industries, totaling 89.92% of the portfolio. This level of concentration is similar to what VUG offers at 87.82%. However, instead of Technology stocks dominating the fund, RPG predominantly holds Oil & Gas, Biotechnology, and Steel stocks.

I want to make a few observations:

1. Oil & Gas E&P and Biotechnology stocks have something in common: poor last quarter results. For example, Oil & Gas E&P stocks missed sales expectations by 0.32% last quarter while the broader market beat by 2.01%. The Magnificent Seven stocks averaged a 4.55% sales surprise, so despite overvaluation arguments, they're at least exceeding analyst expectations. Also, RPG's top sub-industries have relatively poor EPS Revision Scores, which I've derived using Seeking Alpha Factor Grades. I use this score to infer that Wall Street lacks enthusiasm for these stocks, which could limit near-term gains.

2. Commodity-related stocks, which RPG overweights, aren't well-correlated with stocks. To illustrate, the Invesco DB Commodity Index Tracking Fund ETF ( DBC ), an ETF that tracks an Index of 14 commodities, largely went opposite to SPY between 2013 and 2020.

That's a benefit from a diversification and inflation protection perspective but not necessarily from a growth perspective. That's how I view RPG, at least until December's reconstitution.

3. RPG's weighted average estimated sales growth (9.09%) and earnings per share growth (12.98%) are weaker than what VUG offers. Again, this is not a feature I expected for a pure growth fund. I checked my records from December 2022, and RPG's constituents featured 23.42% and 25.33% estimated sales and earnings per share growth, demonstrating the style drift I discussed earlier.

4. RPG trades at 20.92x forward earnings, substantially less than VUG's 33.63x. When the Index last reconstituted, Energy stocks offered a fantastic combination of growth and value, which is how many made their way into deep-value funds like the Pacer US Cash Cows 100 ETF ( COWZ ) and dividend funds like the iShares Core High Dividend ETF ( HDV ). The combination looks excellent on paper, but I've yet to come across an ETF that specifically limits exposure to Energy stocks, where estimates are less reliable because of the difficulty in predicting oil prices.

Unless you're seeking specific inflation protection, as I did with HDV in late 2021 , I urge caution with these "good on paper" funds. Besides, you can always overweight Energy using sector ETFs like XLE and VDE or sub-industry-specific ETFs like XOP , IEO , and OIH .

Investment Recommendation

Invesco S&P 500® Pure Growth ETF's track record is relatively poor compared with plain vanilla growth ETFs like VUG and SPYG. Surprisingly, it underperformed in most years when growth stocks outperformed value stocks, including 2020 and 2023. Potential reasons include reliance on historical factors to assign growth and value scores, style drift that can occur throughout the year in fast-changing markets, and the avoidance of highly profitable mega-cap growth stocks.

Either way, Invesco S&P 500® Pure Growth ETF works best to combat high inflation based on its 30% allocation to Energy stocks, and unfortunately, its constituents no longer offer a compelling earnings growth rate to support a buy rating. Therefore, I recommend readers avoid RPG, and I look forward to continuing this discussion in the comments section below. Thank you for reading.

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