VONG - VBK: We'd Rather Own Large-Cap Growth ETFs Instead

Summary

• VBK invests in U.S. small-cap growth stocks.
• Although VBK's return was good in the past, it still trailed other large-cap growth funds.
• In economic downturns in the past, VBK’s fund price has declined more sharply than its large-cap growth peers.

ETF Overview

Vanguard Small Cap Growth ETF ( VBK ) owns a portfolio of U.S. small-cap growth stocks. VBK has delivered a total return of 404.2% since its inception in 2004. Despite its impressive return, VBK has underperformed against its large-cap growth peers. In addition, its fund price tends to drop more sharply in an economic downturn or when the market sentiment turned extremely negative. Since 2023 is likely going to be a year of economic uncertainty, we think investors should seek shelter in large-cap growth stocks instead.

Fund Analysis

Small-Cap Growth Stocks lagged behind Large-Cap Growth Stocks in the long term

Growth stocks are stocks that generally have long runways of growth. Growth stocks tend to trade at lofty valuations as investors are more willing to pay a hefty premium for the future growth of these companies.

Given long runways of growth, growth stocks, whether belonging to small-cap or large-cap categories, should produce strong returns. This is indeed true. However, Small-cap growth funds such as VBK's total return was more inferior than large-cap growth funds such as Vanguard Russell 1000 Growth ETF ( VONG ) and Vanguard S&P 500 Growth ETF ( VOOG ). As the chart below illustrates, VBK delivered a total return of 151.3% in the past decade. While this was impressive, it was way behind VONG's 290.8% and VOOG's 260.4%.

One may wonder why small-cap growth funds underperformed against their large-cap growth peers. The reality is that small-cap growth stocks may have strong growth profiles, but they are not as established as large-cap growth stocks. The moat they have are not as strong as large-cap stocks. Hence, they are more vulnerable when facing macroeconomic headwinds. On the other hand, large-cap growth stocks tend to be well-established and moaty. They also tend to generate strong cash flows. Therefore, they have the cash to invest to grow and perhaps even return this cash back to shareholders through both buybacks and dividends.

What happens if an economic downturn takes place?

In an economic downturn, small-cap growth stocks are also more vulnerable than large-cap stocks. Not only because their moats are not as strong as its large-cap growth peers, but their cash positions are also not as strong as their large-cap peers. In addition, a lot of small-cap growth stocks are newer or start-ups. They have yet to become profitable. In order to expand their businesses, they need to raise their cash through equity offerings. However, in an economic downturn, investors generally do not have the appetite to invest in companies that are less profitable or not even profitable. Therefore, they may run into liquidity problems.

The result is evident in VBK's fund price versus its large-cap growth peers. As can be seen from the chart below, during the Great Recession in 2008/2009 and the pandemic in 2020, VBK suffered more loss in its share price than other large-cap growth funds such as VONG and VOOG. In addition, when the market sentiment is negative, such as the years 2016, 2019 and last year, the degree of decline of VBK is greater than its large-cap growth peers.

Uncertainty in 2023 can be a headwind for VBK

While many people have expected that the aggressive rate hikes last year by the Federal Reserve will soon tip the economy to a recession in 2023, this has yet to happen. On the other hand, inflation appears to be sticky. While inflation had clearly peaked in mid-2022, the core CPI annual growth rate excluding rent, food, and energy stayed at 4.1% in the past 3 months. In addition, the job market added 517 thousand jobs in January. Moreover, yesterday's retail sales data in January showed signs of strength as retail sales grew by 3%. This means that the Federal Reserve still has more work to do to cool the economy and to fight against inflation. Hence, we expect rates to go higher this year, albeit at a slower pace than last year.

Given higher rates due to inflation, VBK's valuation will likely be depressed. In addition, an earnings recession may continue as the economy eventually heads for a hard landing. Given the greater magnitude of decline for VBK than its peers in an economic downturn, we think it is better to stay away from VBK.

Investor Takeaway

VBK's small-cap growth portfolio may continue to bring positive returns in the long term. However, our analysis shows that large-cap growth stocks offer even better returns. In addition, large-cap growth stocks also usually offer better downside protection in a potential economic downturn. Therefore, we recommend investors stay away from VBK and to focus on large-cap growth stocks instead.

Additional Disclosure : This is not financial advice and that all financial investments carry risks. Investors are expected to seek financial advice from professionals before making any investment.

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