2023-07-19 06:40:52 ET
Summary
- Vanguard Russell 1000 Growth ETF has outperformed the S&P 500 index, with 51.20% of the fund's assets in the technology sector, including Apple and Microsoft.
- The fund has seen a 33% increase year to date in 2023, despite high risk-free interest rates and lack of corporate growth, resulting in P/E expansion.
- While the fund's holdings are considered high-value, current valuations leave little room for failure, leading to a recommendation of holding rather than buying or selling.
- Investors would also benefit from placing a hedge in place. One such hedge is recommended in the article.
Vanguard Russell 1000 Growth ETF ( VONG ) is a low cost ETF with an expense ratio of 0.08%. Since its inception, the fund resulted in outsized returns and outperformed S&P 500 index ( SPY ) by a decent margin. Then again this is no surprise since growth stocks tend to outperform during secular bull markets and most of this fund's existence was during a pretty strong bull market.
The fund holds a total of 443 stocks with an average annual earnings growth rate of 23% but this comes at a high price since the average P/E ratio in the fund is 35 and the average price to book value is 11.3. In total, 51.20% of the fund's assets are in technology sector. As a matter of fact, Apple and Microsoft claim about 25% of the fund's total weight. The fund is heavily skewed towards technology stocks with large cap and mega cap.
VONG's sector weight (Vanguard)
So far 2023 has been a great year for growth stocks and growth funds and VONG is no exception. The fund is up 33% year to date with no sign of slowing down. Many people thought that growth stocks would underperform in an environment where risk-free interest rate is as high as 5.25% but it hasn't happened. After spending most of 2022 in a bear market, growth stocks made a pretty strong comeback with a vengeance.
It looks tricky moving forward though. Current valuations leave very little room for failure and many growth stocks are priced for perfection. Since we didn't see a lot of earnings growth this year, much of stock performance actually came from multiple expansion, more specifically P/E expansion.
VONG's biggest holding claiming 14% of the fund's total weight Apple ( AAPL ) saw its P/E ratio expand from 21 to 33 since January first. Similarly, VONG's second biggest holding Microsoft ( MSFT ) saw its P/E expand from 25 to 39. Meta ( META ) is another company that actually posted a decline in its earnings but its multiple still expanded from 11 to 39. Not shown in the chart below (for visual reasons) is Nvidia ( NVDA ) whose P/E ratio jumped from 60 to 250 due to hopes that its earnings growth will accelerate with increased adoption of AI.
Below is the 5-year earnings growth rates for these companies and it's clear that these companies are not growing as fast as they once were but they are still priced like they were at the peak of their growth cycle. It's clear that the recent rally of tech stocks is not driven by a growth in earnings but mostly driven by people paying more for each dollar they generate (i.e. P/E multiple expansion).
Don't get me wrong, the fund is great and its holdings are some of the greatest companies in the world but they are mostly priced for perfection. How about fund's non-tech stocks. If the recent rally we've seen in growth stocks is mostly isolated to big tech (also known as FAANG+) perhaps we can find better valuations for this fund's non-tech holdings. Below are some of the fund's largest holdings outside of tech. Notice that their P/E ratios also range from 32 to 73 which I would consider sky high especially considering that we are not in a zero-rate environment anymore.
Some of the sky high valuations might have made sense back in 2020 when Fed Funds Rate was 0%, the Fed was busy printing trillions of dollars and corporations were posting 20-25% growth rates but not when rates are higher, the Fed is running a Quantitative Tightening program and corporate earnings are flat-to-down YoY. Last year many "growth" stocks posted no growth even with inflation. After accounting for inflation, earnings were down in double digits in real terms.
S&P Real Earnings Growth (after inflation) (Standard & Poor’s)
Then why should people pay stocks "growth multiples" when growth isn't actually there?
I am not saying that people should short these stocks because that would have disastrous results. Markets can keep rallying for years even after their valuations stop making sense. In 1990s stocks continued to rally for years after Fed chairman Alan Greenspan's famous "Irrational exuberance" speech, calling stocks wildly expensive at the time (imagine if Jerome Powell made a similar speech today). Investors found out that just because stocks are wildly expensive didn't mean they couldn't get even more expensive.
If you are a long term investor with a horizon of multiple decades, today's valuations might not make a difference to you. Those who bought Nasdaq in 2000 when it had a P/E of 85 still came out ahead 23 years later even though it was a pretty bumpy ride especially from 2000 to 2013. If you wait long enough, the market seems to work itself out but not many people might have that long to wait and that much risk tolerance.
I would rate VONG more of a "hold" than buy right now given its valuation but I don't feel comfortable rating it a "sell" either because the sentiment behind tech growth stocks are extremely strong and this could keep the party going for quite some time. I wouldn't want you to miss out on gains but I would also like you to be careful and perhaps place some hedges in place.
One such hedge could be buying put spreads but unfortunately VONG options don't have a lot of liquidity and bid-ask spreads are simply too high. Instead, you can buy put spreads in a similar fund like QQQ ( QQQ ) which correlates very strongly with VONG. If you currently own VONG, you don't sell your shares but instead buy a $350-320 QQQ put spread expiring next March. This will cost you $432 per contract which is your maximum loss for this hedge but if the market has a wild correction or drop like it did in 2016, 2018, 2020 or 2022 (as it seems to do in even years), your portfolio will be protected to a degree where your maximum gain is capped at $2,568 which is almost 600% the price you paid to enter in this contract.
Conclusion
VONG is a great fund with a great collection of stocks and great track record of outperformance but its components have run up too fast this year and it looks a bit pricey. While I don't feel comfortable selling or shorting this fund while the momentum is too strong, I recommend hedging your long bet with protection such as put spreads. Since this fund's option chain has no volume and no liquidity, you can get a similar protection by buying put spreads on a similar fund with much better liquidity, namely QQQ.
For further details see:
VONG Is A Great Fund That Is Priced For Perfection