VUG - VUG: Better Risk-Reward For Investors With Moderate To Modest Risk Tolerance

2023-08-10 21:23:17 ET

Summary

• Large-cap tech stocks have been leading the S&P 500 rally in 2023, making tech-focused ETFs like iShares US Technology ETF attractive for aggressive investors.
• However, investors with moderate risk tolerance may find Vanguard Growth Index Fund ETF Shares a better alternative due to its diversified portfolio and lower risk.
• VUG's 46% exposure to the tech sector allows it to benefit from the sector's bull run while diversification into other sectors lowers the downside risk.

I predicted the end of the bear market in November 2022 and advised investors to ride the recovery with Vanguard Growth Index Fund ETF Shares ( VUG ) because of its exposure to growth stocks. Furthermore, as economic fundamentals improved faster than expected in early 2023, I issued a second recommendation , advising investors to buy more shares. Both of my predictions came true, as VUG's stock has risen more than 30% year to date. In this article, I outline the reasons why investors with a moderate to modest risk tolerance may prefer VUG over tech sector-focused ETFs like the iShares U.S. Technology ETF ( IYW ).

Growth Category Offers Better Risk–Reward Than Tech ETFs

Technology stocks have emerged as the darling of every type of portfolio due to their consistently improving outlook and impressive returns. For example, since 2009, the iShares US Technology ETF Shares have generated a price return of around 1100%. Additionally, the tech sector's weight in the S&P 500 index increased from 15% to roughly 27% during that time. The focus on digitalization and growing demand for artificial intelligence also support the extension of the growth momentum. According to reports , the global AI market could experience a compound annual growth rate of 37% by 2030.

Despite the robust performance and outlook, tech stock prices have a history of big fluctuations and a sudden shift in direction. Tech stocks are especially susceptible to financial, economic, political, and tail-event risks. This is because they have one of the highest betas in the S&P 500. The risk of a healthy price correction is also high considering the notable increase in forward valuations. The sector's forward PE is almost at the point where a significant price correction began in late 2021. If interest rates rise again in September, technology stocks may suffer. Moreover, given the recent surge in crude oil prices, an uptick in inflation could also be damaging to the tech sector-driven bull run.

Given the risk of chasing the potential bull run in the tech sector, sector-focused ETFs like IYW may be a good option for aggressive risk-tolerance investors. It could be a risky bet for investors with moderate to modest risk tolerance. Nonetheless, there are a number of other investment options available that offer lower risk while also presenting the opportunity to benefit from a potential tech-driven bull run.

The growth category-focused Vanguard Growth Index Fund ETF Shares is one of these options because of its better portfolio mix. VUG’s 45% portfolio concentration in the tech sector enables it to capitalize on tech-driven bull runs. Additionally, portfolio diversification across the remaining sectors aids in reducing volatility during downtrends. With a forward PE of nearly 21, the growth category appears to be less expensive than the tech sector, implying a lower risk of a major price correction. Overall, it appears that the growth category offers better risk rewards for investors with moderate to modest risk tolerance. Whereas, ETFs that concentrate only on the technology sector carry a higher risk.

VUG’s Portfolio Mix Makes it a Better Pick

If the tech sector’s upward momentum continues, VUG's portfolio appears to be well-positioned to capitalize on potential gains. Additionally, a number of its portfolio holdings in the tech sector belong to software application and chip-making categories that stand to gain significantly from the AI boom. For example, Microsoft ( MSFT ) has been investing billions of dollars in the AI market. Its capital expenditure increased to a record $28 billion in fiscal 2023 compared to $23.6 billion last year. The increase is mainly attributed to investments in cloud and artificial intelligence. Moreover, the company’s strategy to take a leading position in the AI market contributed to revenue growth for its intelligent cloud unit in the June quarter, with expectations for a significant boost in the coming years. Similarly, NVIDIA ( NVDA ), Advanced Micro Devices ( AMD ), Adobe ( ADBE ), Salesforce ( CRM ), and many others are likely to benefit directly from the AI boom.

Additionally, unlike sector-focused ETFs, VUG’s portfolio includes a number of growth stocks from fast-growing sectors like consumer discretionary and communications. According to FactSet data , the consumer discretionary sector generated 52% earnings growth in the June quarter, thanks to Amazon's ( AMZN ) earnings per share of $0.65 compared to the median estimate of $0.34. Amazon is the third largest stock holding in VUG's portfolio. In terms of earnings growth, the communication sector ranked second among the S&P 500 sectors in the June quarter. Meta ( META ) and Alphabet ( GOOG ) ( GOOGL ) from the communications sector are among the VUG's top ten stock holdings. Meta outperformed expectations in the June quarter and raised its full-year guidance, while Alphabet sees online advertising recovery and potential revenue growth from AI. Meta's stock is up 153% so far in 2023, while Alphabet's stock is up around 50%.

Furthermore, VUG’s portfolio also includes growth stocks from healthcare, financials, industrials, and consumer defensive sectors. Growth stocks in these sectors do not typically generate price appreciation like tech stocks. However, they can perform well in both bullish and bearish conditions. In particular, stocks from these sectors can help lower portfolio volatility during downtrends. For instance, the healthcare company Eli Lilly ( LLY ) saw a 24% price gain during the 2023’s bull run and a 34% appreciation during the 2022’s bear market. Similarly, Visa ( V ) has performed well so far in 2023 and provided protection in 2022.

Quant Rating

According to Seeking Alpha's quant rating, the Vanguard Growth Index Fund ETF is currently hovering close to the strong buy zone. Besides a dividend factor, which isn't important when chasing returns through price appreciation, the rest of its quant factors earned solid grades. It received an A-plus score on the momentum factor, indicating that shares have solid upside momentum. Technically, stocks or ETFs with solid momentum are generally presumed to have greater potential to extend the uptrend in the future.

Because of a low expense ratio of 0.04%, VUG also appears like a solid long-term investment option. The expense ratio is important because it determines the percentage of fees charged for holding a stake in the ETF. Moreover, the negative B grade on a risk factor vindicates my stance that VUG’s portfolio appears to be less risky due to diversification across multiple sectors. A low short-interest ratio and high turnover also indicate lower risk. Furthermore, with $92 billion in assets under management and 878.51K shares in daily trading volume, VUG earned an A-plus grade on the liquidity factor. Higher trading volumes mean greater investor interest and confidence in the ETF.

Meanwhile, IYW earned a quant score of 4.64 and strong buy ratings from SA’s quant system. The taller quant score is mainly attributed to robust share price momentum over the past three and six months. A solid liquidity score also added to its strong buy ratings. However, the rest of its quant factors are unimpressive when compared to VUG. Particularly, IYW carries a significant risk. It earned a negative C grade on the risk factor due to its high standard deviation and low diversification. In addition, its expense ratio of 0.39% is also higher than VUG's 0.04%.

Risk Factors to Consider with VUG

Although a growth-focused ETF looks less risky than a tech sector-focused ETF, it still carries a number of risks due to its exposure to tech stocks. The biggest risk factor may be the Fed’s interest rate policy. Currently, the market does not expect more rate hikes in the second half. However, if the Fed increases rates in September and keeps them higher for a longer time, there may be volatility in tech stocks. Moreover, if AI hype does not translate into robust revenue and earnings growth for tech companies, there may be volatility for tech stocks.

In Conclusion

Despite having a robust outlook, the tech sector also has a history of making sharp selloffs during tough economic conditions and tail events. Therefore, it's crucial to consider the risk factors when chasing tech sector-focused ETFs. In my view, growth ETFs like VUG offer a better portfolio combination to benefit from tech-driven bull runs while lowering the risk factor in case of downtrends. Moreover, its lower expense ratio and higher liquidity also make it a better long-term investment option.

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