ARKK - VUG: Recent Months Have Shown Very Limited Upside For 2024

2023-12-18 11:46:48 ET

Summary

• After yet another strong year for growth stocks, Vanguard Growth Index Fund ETF Shares is unlikely to deliver satisfactory returns in 2024.
• Current price levels are already built on the assumption that financial conditions will improve even further over the next year.
• At the same time, record-high earnings in 2023 did not have a material impact on performance, which is another red flag for investors.
• Although the VUG ETF is to be preferred over other growth-oriented ETFs, its current risk-reward profile is skewed to the downside.

The Vanguard Growth Index Fund ETF Shares ( VUG ) is one of the most popular choices for investors looking for a basket of high quality growth names. Instead of picking individual growth stocks and bearing significant idiosyncratic risk, the exchange-traded fund ("ETF") gives you exposure to many of the most popular technology names.

After years of delivering strong returns, largely on the back of loose monetary conditions, the ETF's upside is now very limited while, at the same time, holders are bearing significant downside risk.

I outlined those risks back in July of this year, and since then VUG has appreciated by more than 7% in value, thus outperforming the broader equity market.

Although 7% might not be considered a bad return for a period of less than 6 months, investors should keep in mind the level of risk they are taking to achieve that - and more importantly, what's in store for 2024.

It's All About Liquidity

Unfortunately, the aforementioned performance of the VUG has little to do with the narrative-driven investment thesis for the ETF's technology holdings.

As we will see in the next section, earnings performance of the fund's top 10 holdings has actually been exceptionally strong, but the market had already taken this into account. As a matter of fact, it was the sharp reversal of long-term bond yields which drove the term premium to a record low in a matter of weeks. The 10-year Treasury yield (US10Y), for example, fell from nearly 5% in October to below 4% as of today.

In recent years, the yield on long-dated bonds has been a key driver of VUG. When yields were low, the ETF has delivered significant total returns and vice versa. This year might look as an outlier on the graph below, but in fact, yields have increased at a far smaller pace than initially expected, and as we saw above are on track to fall even further (at least this appears to be the current expectation).

In one of my recent articles on ARK Innovation ETF ( ARKK ), I outlined the mechanism through which the yields were severely impacted by the U.S. Treasury's announcement on 1st of November to reduce the relative share of long-dated bonds that it is going to issue in the coming months.

That is why the next announcement, in about a month and a half, could have profound implications for the future returns of growth stocks and ETFs such as the VUG.

On top of this major tailwind for the VUG, the market is now pricing-in a significant reduction of the federal funds rate over the course of 2024.

I recently took a deep dive on how this is going to impact different areas of the equity market and what it means for the overall outlook for 2024.

When taken together, all that resulted in one of the most supportive macroeconomic environments for growth stocks, since the monetary experiment following the pandemic.

And after all, this has caused a very limited upside both in VUG and the broader equity market as well.

The disparity between the supportive financial conditions and the limited response of VUG highlights the limited upside potential and the stronger downside risk as we enter 202.4

Business Performance Hardly Matters

In addition to the highly supportive monetary environment, VUG's individual holdings also experienced a significant tailwind in recent months that also wasn't able to propel the ETF to new all-time highs.

Before I go into it, however, I would like to highlight the fact that VUG's holdings are high quality growth stocks, and as such they offer significant downside protection relatively to the low-margin holdings of ARKK, for example.

Therefore, I would prefer holding the VUG as opposed to an ETF like ARKK, if I had a positive outlook for growth stocks in 2024.

Having said that, the VUG also has an issue with extreme concentration into a couple of big tech names, with the weight of the top 10 holdings standing at above 50%.

The tailwind that I mentioned above was the strong quarterly earnings performance of almost all of VUG's holdings in recent months. As we see on the graph below, almost all of the top 10 holdings reported a significant earnings surprise during their last reported quarter.

With the exception of Amazon ( AMZN ) and Eli Lilly ( LLY ) which both had significant one-off items in their latest earnings reports, and Tesla ( TSLA ), the rest of the top 10 holdings reported earnings above the already high consensus estimates.

Conclusion

It is hard to conceive an even more supportive environment for the VUG's returns, given the very loose monetary conditions in 2023 and the strong earnings of the fund's holdings. In spite of all that, VUG appreciated in value by roughly 7% since I first covered it in July.

That is why we would require an even more supportive environment for growth stocks in 2024, alongside a sustained momentum in earnings. Although this is certainly possible, I don't see it as a likely scenario, and as such, the risk-reward profile of the VUG is highly skewed toward the downside.

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