Equity ETF investor must-knows: Assessing value versus growth

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2014 US macro must-knows for equity and fixed income ETF investors (Part 2 of 5)

(Continued from Part 1)

ETF value versus growth

The below graph looks at the performance of value versus growth indices compared to much broader indices—the Russell 2000 and the S&P 500. While the broadest of indices, the Russell 2000, outperformed all other indices, it’s important to note that, relative to the S&P 500, the Growth Index outperformed both the S&P 500 and the Value Index, and that the Value Index was the lowest-performing index of all. This pattern suggests that, in the case of economic recovery and rising stock prices, exposure to growth companies may outperform value companies, and that the broadest index exposure to a larger number of smaller companies in general (as reflected in the Russell 2000 index) may offer the best upside potential.

For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.

Value stocks outperform growth stocks in the long run

Despite the recent outperformce of growth stocks in the post-2008 economic recovery, in the long run, and over several business cycles, academic studies tend to show that value stocks outperform growth stocks. One value versus growth study, by Chan & Lakonishok, involving data from 1969 to 2001—the peak of the dot com bubble growth stock phase—showed that, even during this period, smaller-value companies outperformed growth stocks by 18% over this 22-year period.

Value stocks tend to hold up better in declining markets

Plus, as the below chart demonstrates, during weak equity market periods, such as the DotCom crisis of 2002 or the financial crisis of 2008, value stocks held up much better than growth stocks, and they tend to do so when the future direction of the economy looks bleak.

Category/Index     2002   2003   2004   2005   2006   2007   2008   2009   2010   2011

Large Growth        -27.64   28.66     7.81    6.71     7.05   13.35  -40.67  35.68   15.53   -2.46
Large Value           -18.69  28.44    12.97    5.95   18.15    1.42   -37.09   24.13   13.66   -0.75
S&P 500                -22.10  28.69    10.88   4.91     15.79    5.49  -37.00   26.46   15.06    2.11

Mid-cap Growth     -27.24  35.96    13.23    9.84     9.00   15.09  -43.77   39.11   24.61   -3.96
Mid-cap Value       -13.25  33.85    17.85    8.82   15.87    0.83   -36.77   35.41   21.92   -3.96
S&P Midcap 400    -14.53   35.62    16.48  12.56    10.32   7.98  -36.23   37.38   26.64  -1.73

Small-cap Growth  -27.88  45.54    12.41     6.02   10.81     7.59  -41.55   35.46  26.98  -3.55
Small-cap Value   -10.12  42.38    21.14    6.40    16.27   -6.08  -32.24   31.32   26.17   -4.45
Russell 2000        -20.48  47.25     18.33    4.55    18.37   -1.57   -33.79   27.17   26.86   -4.18

Source: Morningstar

As a result, investors concerned about a major decline in global equity prices or suddenly weakening economic data may wish to consider weighting value shares over growth shares in their portfolio. Alternatively, if investors are confident that global economic growth will remain firm, and that earnings will remain strong, an allocation to growth stocks over value stocks may be more appropriate.

To see how fixed income ETF performance varies depending upon credit quality and the duration of the portfolio holdings, please see the next article in this series.

To see how various fixed income ETFs compare to one another in the current macroeconomic environment, please see Key strategy: Will deflation contain the bear market in bonds?

Equity outlook: Cautious

Should the debt ceiling debate re-emerge and macroeconomic data fail to rebound in sync with record corporate profits, investors may wish to consider limiting excessive exposure to the U.S. domestic economy, as reflected more completely in the iShares Russell 2000 Index (IWM). Alternatively, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD). Plus, even the global blue chip shares in the S&P 500 or Dow Jones could come under pressure in a rising interest rate environment accompanied by slowing consumption, investment, and economic growth. So investors may exercise greater caution when investing in the State Street Global Advisors S&P 500 SPDR (SPY) or the State Street Global Advisors Dow Jones SPDR (DIA) ETFs. Until there’s greater progress on the sequester issue, and consumption, investment, and GDP start to show greater signs of self-sustained growth, investors may wish to exercise caution and consider value and defensive sectors for investment or individual companies such as Wal-Mart Stores (WMT).

Equity outlook: Constructive

However, if investors are confident in the USA’s ability to sustain the current economic recovery as a result of a constructive debt ceiling accord, either before or after the mid-term elections this year, they may be willing to take a longer-term view and invest in U.S. equities at their current prices. With the Schiller S&P 500 price-to-earnings ratio standing at 25.39 versus the historical average of around 15.50, the S&P is slightly rich in price, though earnings have been solid. However, with so much wealth sitting in risk-free and short-term financial assets, it’s possible to imagine that a large reallocation of capital that’s “on strike,” including corporate profits, into long-term fixed investments could lead to greater economic growth rates in the future—and support both higher equity and housing prices as well. In the case of a constructive outlook, investors should consider investing in growth through the iShares Russell 1000 Growth Index (IWF) or through individual growth-oriented companies such as Google (GOOG).

Continue to Part 3

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