Exposure to large U.S. growth stocks has been one of the year’s most successful investment strategies. The Russell 1000 Growth Index outpaced the Russell 1000 Value Index by a remarkable 10 percentage points through mid-August, following a nearly 20 point lead in 2017. Today, we find that a majority of client portfolios we analyze are overweight growth stocks as a result—some substantially—putting those investors at risk should the FAANG-dominated technology sector fail to deliver in coming quarters.
Portfolios are overweight growth
Given the strong performance of the large growth category, it makes sense that growth funds would now represent a larger weighting of client portfolios due to market gains and the desire to allocate additional assets to these strategies. However, a review of nearly 400 advisor model portfolios by our portfolio consulting team revealed another, less obvious, source of growth bias: core equity and value funds that have stretched to own growth stocks.
By looking through to the underlying holdings of each fund and exchange-traded fund (ETF) in the cohort of portfolios, and combining those with the client’s individual equity holdings, we were able to get a more holistic view of aggregate equity exposure. What we found was surprising: 70% of advisors in our sample had at least one model portfolio with a growth bias beyond what exists in the S&P 500 Index today. Nearly a third of all the portfolios we analyzed had an extreme growth bias—weightings at least 10 percentage points higher than the overall market. One explanation is that many of the funds in Morningstar’s core and value categories have drifted into the growth space by stocking up on some of the year’s highest-multiple—and best-performing—technology names, where price-to-earnings (P/E) ratios often exceed 100 times earnings. It’s clear that many well-meaning allocations to “value” are not providing the diversification potential clients are expecting.
Another source of growth bias and tech concentration came from broad-based market exposure. Tech now represents 42% of the Russell 1000 Growth Index, making it far and away the key driver of performance of the Russell 1000 Growth Index this year. But tech has also had a big impact on the S&P 500 Index, where it now makes up more than 25% of the index and every one of its five largest holdings, boosting the S&P’s growth exposure along with it. In theory, market-capitalization-weighted ETF strategies that track these benchmarks are providing clients with broad market exposure; in reality, they’re helping further tilt the balance in favor of growth.
A key risk to watch in the coming quarters
What could go wrong? After all, companies such as Alphabet and Netflix have proven their ability to create value and grow earnings over the past several years. The most crucial factor will be whether tech companies’ earnings can continue to accelerate. And while earnings estimates continue to move higher along with tech stock prices (a healthy sign), analyst estimates for tech earnings over the coming quarters are actually lower than those of the S&P 500 Index overall. If we do see technology earnings come in behind the broader market later this year and into 2019, as analysts expect, it could be the catalyst that investors need to rotate into value. A correction in the sector could also be swift, as the momentum factor can be a powerful driver of returns on the way up—but also on the way down. Valuations on growth stocks are becoming increasingly rich relative to value. The premium of the S&P 500 Growth Index versus the S&P 500 Value Index is currently 39%, well above the 10-year average premium of 19%.1
Adding a margin of safety
For more than two years we’ve highlighted equity sectors—including technology—that offer growth at a reasonable price in the pages of our Market Intelligence outlook. Current earnings estimates for the tech sector constitute a warning sign, and we’ll be watching closely for negative earnings trends that could downgrade our view. Given tech’s nearly 20% return year to date and the central role it plays in the oversize growth exposure across client portfolios, now may be the time to develop a plan for rebalancing assets to value. The premise of value investing—purchasing shares of a company below its intrinsic value—is designed to provide a margin of safety to investors when the market periodically resets prices to match lowered expectations for earnings growth. This benefit was clearly on display during the 2000 correction, where value sharply outperformed growth as elevated tech valuations came back down to earth.
It’s also important to note that the changes in performance leadership between growth and value are generally not short-lived, with one style maintaining an edge for several years before the situation reverses. At the time of this writing, the Russell 1000 Growth Index has outperformed its value counterpart in 7 of the past 11 years, and the knock-on effects can be seen across client portfolios. Reviewing equity holdings for growth bias and adding a margin of safety—with attention to value style purity—now may better position clients as we enter what may well be the final innings of this historic bull market.
1. Source: FactSet, as of 8/24/18.