Picking The Best Growth/Value ETFs

With all the talk about “smart beta” and factor investing, it’s easy to forget that virtually all of the newfangled ETFs being launched every week owe a debt of gratitude to the most famous factors of all—the Fama-French factors.

The seminal 1992 work by Eugene Fama and Kenneth French divided up stock market returns into factors so common we don’t even think of them as factors anymore—size and style.

From those basic insights, a fundamental framework for how many investors view the market was formed—the so-called style box popularized by Morningstar, and widely used throughout popular finance.

Size is perhaps the easiest thing for most investors to grasp. Over time, it’s been shown that companies of a given size tend to perform similarly to each other—so that in a regime where large-caps are in favor, the average large-cap is doing better than the average small-cap. Over the last five years, for instance, it’s been a midcap-favoring market:

Midcaps, represented here by the MSCI US MidCap index, are a solid 11 percent higher than large-caps, with small-caps in last place.

Of course, as with any factor, we’re looking across thousands of stocks here. There are large-cap stocks that have beaten the pants off the average small-cap, and vice versa. But size is one of the things at work.

But once we step away from the super-easy-to-understand world of “market cap” as a factor, things immediately get hairy. In their original work, Fama and French settled on a single variable to measure “style”—a word they didn’t even use: price-to-book value (P/B).

Growth Tricky To Identify

Most of us think of “P/B” as a basic measure of value, especially in a classic Ben Graham-style value hunter’s parlance. When I see that Richfield’s P/B is “0.5” I know that means the market is saying, “This company is trading at half its accounting value.” Sometimes there’s a very good reason for that, but sometimes it means a stock is actually genuinely undervalued—that’s the premise of value investing.

The problem is defining what the other end of the spectrum looks like. A high P/B isn’t necessarily a clean definition of a “growth” company. In fact, very few otherwise-rational investors can even agree on what it means to be a “growth” company.

Clearly, “growing” must be part of it, but how do you measure that? Price growth? Well, we generally call that factor “momentum.” Dividend growth? Well, we tend to pull that off to the side and make buckets of “dividend companies.” Earnings growth? Sure, but at what price? Hence the whole “growth at a reasonable price” approach made famous by Fidelity’s Peter Lynch in the 1980s.

Our Analyst Picks

There isn’t a right answer, of course, which is how we’ve often ended up twisted in knots here at ETF Analytics trying to help investors pick the “best” growth and value funds. It’s clear enough in terms of our scoring system—we rate funds on quantifiable properties, and compare them against neutral benchmarks.

But we also produce our “Analyst Picks” in popular segments. These are funds that we, as a team, decide best represent the core thesis of each segment, and that are also sound, tradable funds.

How then to parse the size-and-style funds? Our previous approach had been to look at each individual segment in a vacuum—large-cap value need not have any connection to small-cap growth. Feedback from heavy users of our Analyst Picks, however—particularly inside the due diligence operations of large wealth management and brokerage firms—has been that consistency across the style box is incredibly important.

Put another way—large-cap growth needs to make sense in the context of our choice for small-cap value, because investors and advisors often rotate between boxes, or construct blended portfolios of, say, a small-cap value fund and a midcap growth fund.

Our ‘Style Box’ Fund Picks

With this in mind, here are our new choices for the “style box” funds—all from the same family, all using the same methodologies:

The Guggenheim Pure Series

Guggenheim S&P 500 Pure Growth (RPG | A-76)

Guggenheim S&P 500 Pure Value (RPV | A-69)

Guggenheim S&P 400 MidCap 400 Pure Growth (RFG | A-70)

Guggenheim S&P 400 MidCap 400 Pure Value (RFV | B-64)

Guggenheim S&P SmallCap 600 Pure Growth (RZG | B-86)

Guggenheim S&P SmallCap 600 Pure Value (RZV | B-57)

By selecting a group here, we’ve had to make some compromises. Not every fund here trades like water—if you wade into the small-caps, you’ll need to be careful in your executions. And it’s based on the S&P definition of small/mid/large, which has its own issues (notably, the presence of midcaps in the S&P 500).

But what we gain is important too. The growth funds pick (and weight) the stocks from the parent S&P indexes based on sales and earnings growth, along with price momentum. The value funds look at P/B, sales/price and P/E. Importantly, stocks that are only middling in these measures, or which exhibit both growth and value characteristics are kicked out.

The end result is portfolios that are simply more dissimilar than if you took the S&P 500 and split it into growth and value buckets, with all the slop in the middle included.

Over short-term periods of time, this means getting rewarded for getting the style call right more—or punished for getting it wrong. 

Year-to-date, for instance, the pure growth fund has been the best performer, and the pure value and regular value funds tied for worst. Curiously, over longer time horizons, both versions tend to do better than the “less pure” varieties. Here’s the five-year chart:

I suspect that there are two things at work here. While it’s true that the “pure” methodology better isolates the growth and value factors, the fact that they also “weight” based on those factors breaks the cap-weighted nature of most indexes and the market itself.

Given that we’ve been in a midcap world for the past five years, the pure series has provided an added boost. For example, the weighted average market cap of the pure value fund is just $38 billion. The regular version? $113 billion.

Regardless, we all know past performance is no guarantee of future results. We’re excited to offer up this set of recommendations for investors with a style-box view of the world. There are plenty of fine funds competing with them, but as a suite, we think these six funds provide the counter-correlation and style purity that will best reward you for your insights.

Dave Nadig is the director of exchange-traded funds at FactSet Research Systems. At the time of this writing, the author held no positions in the securities mentioned. You can reach Dave at [email protected], or on Twitter @DaveNadig.