Ideas to Tackle Risk in Hot Growth ETFs

Performance has been strong. Media buzz is even stronger. Watching growth run-up has made for exciting charts and colorful conversation. But that doesn’t mean growth can’t start to look expensive. It feeds some nervousness given its concentration on a few names and sectors. Not to mention its vulnerability to economic conditions and the rate environment.

This year, we’ve been talking a lot about the ongoing pursuit of diversification among ETF investors. Advisor surveys suggest a growing concern. Asset flows into things like liquid alternatives confirm the jitters. Bulls are still plenty bullish, but there’s a growing call for caution. What if rates don’t come down or if geopolitical tensions burn hotter? What if the economy cools down and what if sticky inflation proves stickier?And what if upcoming elections do us all in?

There is good news, though. When it comes to equity growth investing, there are ways to manage risk without having to give up on participation.

Many see QQQ as a benchmark for high-flying growth even though the fund isn’t designed to be a growth fund. The Qs simply track the Nasdaq 100 Index. It comprises the 100 largest stocks listed on the Nasdaq board, excluding financials. It so happens that a lot of the stocks listed on the Nasdaq are growth darlings. Many pf them are in the tech sector. And the Qs are capturing that unique universe. That has made the fund a popular proxy for all of the action in growth.

So far in 2024, QQQ is among the top four asset gatherers. It took in some $15 billion in net new assets as of early June. Its “mini-me” counterpart, (QQQM B), has taken in more than $5.5 billion. Collectively, the Qs have hauled in more than $20 billion year to date. A haul that exceeds $30 billion if we extend it to a 12-month time frame. There’s been a lot of money chasing this opportunity.

But the Qs aren’t the only way to think about growth. If you are seriously bullish on growth, you can get more laser-focused with growth-specific ETFs – a fund like (SPYG A-), for example – vs. a growth-like ETF such as QQQ.

SPYG selects and market-cap weights growth companies within the S&P 500. In the current environment where concentration on a few growth names has driven most of the results, SPYG’s focus has translated into outperformance relative to the S&P 500. It has also translated into lofty valuations. Yes, true growth investors aren’t as concerned about valuations as they are about the future potential of reward that will justify the high price tag today, but still, the current forward P/E for SPYG is 29, which compares to 22 for SPY (itself flirting with record highs), and 16.8 for its value counterpart, (SPYV A).

Valuations often don’t deter growth investors. However, they may be starting to give some investors some pause as uncertainty about what’s ahead feeds concerns about risk.

The good news is that there are ways to access growth through fundamental and factor screens in search of quality and attractive value within the space, all to play a little defense.

One example is the American Century US Quality Growth ETF (QGRO B-). The portfolio, which is about 20% smaller than SPYG in number of holdings, considers profitability, return on assets, and momentum to find quality companies delivering stable growth. The strategy then looks at cash flows, earnings, sales, and valuation metrics to create a “growth score” for each security, which defines its weighting scheme.

This quality-focused approach to capturing growth is delivering a portfolio that brings lower single-security risk while capturing growth’s momentum and upside. Top holdings such as Alphabet sit at about 3% of the portfolio vs. 12.5% for SPYG; a company like Nvidia – the market’s current darling – represents only 2.2% of QGRO versus 11% for SPYG, and Microsoft, which is SPYG’s biggest holding at 12.5% sits at under 2% in QGRO.

Rene Casis, portfolio manager of QGRO, tells us that narrowness in leadership within growth portfolios is a concern many advisors are bringing up, something that a strategy like QGRO looks to mitigate by capping maximum weights to single securities at 3.5%.

Differences in sector tilts are also meaningful. Consider some stats comparing QGRO vs SPYG vs QQQ:

In the past year, Communications Services (32%), Information Technology (26%), Financials (26%) and Industrials (21%) have been the four best-performing sectors in the S&P 500, which is up 23% in the past 12 months.

While QGRO allocated more heavily to the latter two, it under-allocated to the leading two sectors relative to SPYG and QQQ due to its quality focus. Performance and path of returns (investor experience) have differed as a result, but not as much as we may have expected. Upside capture is strong. Growth has worked well even within the guardrails that quality and valuation may provide.

“If you believe in reversions to the mean, when growth reverts, quality can help investors remain allocated while still being able to capture upside participation,” Casis said.

Another way to access growth in a more “defensive” way is through what is known as “growth at a reasonable price (GARP).”

GARP strategies implement a value screen to their security selection, and in at least one case diversify the portfolio beyond equities in search of growth opportunities at a compelling value in other asset classes.

Consider the Invesco S&P 500 GARP ETF (SPGP A-) as an example. The fund picks 75 companies from the S&P 500 that are strong growth names but that are also quality and attractively priced. The index underlying the strategy brings it all together to create growth and quality scores, and weights accordingly.

SPGP is a massive fund, with almost $5 billion in total assets. And while, like QGRO, it uses quality and valuations as key metrics in its stock selection, the portfolio takes valuation seriously. The result is a mix that tilts much more heavily into sectors such as energy and materials vs. QGRO, and less into technology and communications services, which have been lead performers. In fact, SPGP is currently betting as much on energy as it is on tech from a sector perspective. These tilts help explain its relative underperformance vs. QGRO in the past year and offer an interesting perspective on what a growth portfolio can look like.

Diamondback Energy, Marathon Oil, and Enphase Energy are all among the top holdings in SPGP, as are NPX Semiconductors. What’s not there is equally noteworthy: Alphabet, Meta, and Nvidia – some of the names populating QGRO’s biggest security allocations.

What’s interesting about this space is that quality and GARP don’t necessarily lead to the same outcome. Look at the iShares MSCI USA Quality GARP ETF (GARP A-), for example.

The fund is designed to be a growth portfolio that’s also sensitive to valuations and intentional about quality. But the top holdings here look a lot like the big growth names you’d expect to see in all-in growth funds: Nvidia, Apple, Eli Lilly, and Microsoft. In fact, technology is 45% of the portfolio allocation, and communications is another 10%. Energy and materials, together, amount to just over 5% of all sector weights.

A look at the underlying index methodology shows that stock selection is based on a combination of measures of growth, and value and quality screens come into play in the weighting scheme. That’s probably what leads to a stock mix that includes a lot of high-flyers, even if it tones down weights relative to other growth funds.

Finally, there’s moat investing. Invest in quality companies that have competitive advantages relative to their segment peers and are delivering sustainable growth and profitability.

VanEck is one of the pioneers of moat investing in ETFs, and the firm just added earlier this year to its family of Moat ETFs the VanEck Morningstar Wide Moat Growth ETF (MGRO). It’s still very early days for the fund, but the launch two months ago seems timely as investors consider alternative ways to capture growth while managing risk.

There are many ways to access equity growth through ETFs. If valuations for growth companies are starting to make you nervous as you get ready to dive into mid-year outlooks and consider near-term and long-term allocations, many ETF providers offer today various ways with which to remain invested in growth while managing risk more granularly.

As always, our ETF Screener a good place to start your research. And if we can help with your due diligence, let us know!

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