Growth Funds Are Poised to Outshine Again. Here’s How to Pick the Right Ones.

January’s strong jobs report gave many investors the impression that the Fed may still have a long way to go in raising interest rates before it can quell rising inflation. But the collapse of the Silicon Valley bank in March — and its aftermath — has caused many to reassess the resilience of the country’s financial system and wonder if the central bank has already gone too far. Traders are now forecasting a 98% chance that the Fed will cut its target interest rates by the end of the year.

A stable – or even easy – interest rate environment is good for growth companies, as it would encourage investors to shift money from the bond market to higher-risk, higher-yielding assets. Lower borrowing costs also make it easier for companies to raise money and grow their businesses.

Some investors have already started the move. In March, US exchange-traded funds focused on large-cap growth stocks attracted $3.8 billion in new assets, while large-cap value funds lost about the same amount.

After its peak in November 2021, the

Russell 1000 growth

The ETF (ticker: IMF) had lost almost a third of its value by the end of last year. However, in the first quarter of 2023, the fund skyrocketed 14%, which is double the return

S&P500

Index.

Stocks of larger growth companies are even more popular. The

Schwab large-cap growth in the US

The ETF (SCHG) gained 17% in the first quarter and the

Vanguard Mega Cap Growth

ETF (MGK) up 19%. Both funds have a weighted average market cap of more than $850 billion, according to FactSet.

In contrast, small-cap growth funds are lagging, despite their valuations being much lower. In the first quarter the

iShares S&P Small-Cap 600 Growth

ETF (IJT) and

Invesco S&P SmallCap 600 Pure Growth

ETF (RZG) both gained less than 2%.

This reflects market concern that the Fed’s tightening could still lead the economy to a hard landing. Small companies tend to underperform during recessions because they don’t have the same resources as large companies to weather the tough times.

However, investors seeking growth exposure through index-based ETFs should exercise caution. Due to the dramatic shift in market dynamics over the past year, some growth funds may no longer hold what were considered growth stocks over the past decade.

Tech giants like Alphabet (GOOGL) and Amazon.com (AMZN) have been the flagship growth companies for years. However, following the recent reshuffle of the S&P Dow Jones indices, they are no longer classified as “pure growth” stocks. The group’s strong sales and earnings during the pandemic have made it difficult to sustain high growth rates, especially in the face of the Fed’s aggressive rate hikes.

Meanwhile, fossil giants like Exxon Mobil (XOM) and Chevron

(CVX) have seen their fortunes turn. As Russia’s years-long war in Ukraine sparked an acute energy crisis around the world, oil and gas prices soared and energy companies made record profits. After their stocks have rallied over the past year, some have exited the value space — which they’ve been in for more than a decade — and become the new champions of growth.

All of this means that investors should look closely under the hood of growth ETFs. Your holdings may have been more consistent in the past, but could differ wildly given different rebalancing schedules and stock picking standards in today’s market.

Invesco S&P 500 Pure growth

(RPG), for example, currently holds 28% in energy stocks and just 14% in technology, while

iShares S&P 500 growth

(IVW) has 34% in technology and only 8% in energy. Vanguard Mega Cap Growth has more than 50% technology and less than 1% energy

First Trust Large Cap Growth AlphaDEX

(FTC) has 16% and 19% respectively in the two sectors.

Instead of index funds driven by mathematical rules, some investors may prefer actively managed funds with stocks handpicked by portfolio managers who can see things in companies in ways algorithms can’t.

The trick to choosing an active growth fund is to separate the managers who dig deep into their research to achieve long-term outperformance from those who just dribble buzzwords about technology and trends, says Russel Kinnel, director of manager research at Morningstar.

“The first thing you need to do is turn off the short-term power,” says Kinnel. He looks for funds with strong long-term records that have outperformed their peers in 2022. “When you can buy a really good investor whose portfolio has fallen out of favor, that’s often a good time,” he says.

Investors should never pay outrageous fees, no matter how smart the fund manager sounds, says Kinnel. He recommends three budget mutual funds that have ranked in the top third among their peers over the past 15 years but have fallen to the bottom 20% in 2022 –

International growth of avant-garde

(VWIGX),

appreciation of port capital

(HCAIX) and

T. Rowe Price Blue Chip Growth

(TRBCX).

With all the market uncertainties, the growth recovery may not be immediate and investors need to be prepared for more ups and downs. “If stocks are down, that should be enough to give you a nice return over the next 10 years,” says Kinnel. “The real risk is buying at the peak. I’m not overly concerned after a blowout year like last year.”

write to Evie Liu at [email protected]