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By Michael Rawson, CFA

Most equity portfolio managers follow one of two investment philosophies: value or growth. Value managers look for inexpensive stocks; growth managers look for great businesses with attractive stories. In this article, we take a look at the definitions of value and growth and suggest some exchange-traded funds to use for style investing.

Defining Style
While indexing had been around for some time, it was not until the 1980s that indexes were developed to track the value and growth styles. Broad--or core--indexes are easy to define, as they include all stocks within a certain size threshold. But style indexes rely on filtering rules to sort stocks by value or growth. In concept, a value stock is one that sells at a low price relative to some measure of worth while a growth stock is one that has a potential for fast earnings growth. Value stocks are easy to identify using ratios of the current stock price to historical financial-statement items, such as earnings or book value, to form valuation multiples such as price/earnings or price/book.

The inverse of the price/earnings ratio is called the earnings yield and can be thought of as an interest rate or rate of return on a stock. We can think of the earnings yield as being similar to the yield to maturity on a bond, holding aside the fact that not all earnings are paid out as dividends. While it is common to think of a stock trading at a low P/E ratio or a high earnings yield as being a good value and offering the potential for a high return, it may also entail greater risk, just like a junk bond trading at a high yield to maturity is typically thought of as being risky.

Growth, on the other hand, is much more difficult to identify. By the time growth can be measured in historical data, such as historical sales or earnings growth, the share price is usually bid up to reflect the prospect of strong future growth to the point that future returns are poor. A better approach, then, is to use forward-looking measures such as analysts' earnings or growth forecasts. The problem with analyst forecasts is that analysts are no faster at recognizing growth than the rest of the market, so by the time it is clear that a company will grow, the stock price has already risen. Because it is so hard to project growth from historical figures, some have suggested using stock-price momentum as an early indicator of growth. Because growth involves change, momentum may be a good way to identify companies undergoing change. However, momentum is often seen as a third investment philosophy, distinct from value and growth. By putting the best momentum stocks in the growth bucket, the remaining value stocks will be saddled with poor momentum. Stocks traditionally seen as value stocks can also exhibit momentum, particularly related to changes in the business cycle.

Another way to look at growth and value is by sector. Mature industries that are capital intensive are often seen as value, while technology or consumer-products and consumer-services industries, where trends play a larger role, are often seen as growth. Value companies typically pay out a dividend because they do not have many growth opportunities that require new capital. Because they are earning returns above their cost of capital, growth companies typically reinvest their earnings back into their businesses rather than pay out dividends.

The four major index providers use a variety of measures to define value and growth. Russell uses two metrics (the ratio of book value/stock price and analysts' long-term growth forecasts), while MSCI uses as many as eight measures. Ideally, the methods should produce distinct portfolios that have a low correlation with each other and a high correlation with the returns to value or growth factors. After sorting, the one third of the stocks with the deepest value metric are placed in the value index and the one third with the highest growth scores are placed in the growth index. The remaining one third, which have some characteristics of both value and growth, are distributed between the indexes so that these stocks will have a partial weighting in value and a partial weighting in growth. Because the indexes are designed to have this overlap, the correlation will generally be high and the style purity of the growth and value indexes is diminished. Over the past 10 years, S&P's style indexes had the highest correlation with each other, while MSCI had the lowest. To address this problem, S&P revised its methodology to include momentum as a growth factor and introduced an additional set of style indexes named "pure" value and growth, which do not have any overlap and are weighted by style score instead of market cap. Whereas the S&P 500 Value and Growth indexes have had a correlation with each other of 0.86 over the past 10 years, these pure style indexes have had a lower correlation of 0.70.

Value for the Long Term
Over time, value stocks have been shown to outperform growth stocks. Not only do they have a slightly higher return, they also have a lower volatility. Over the past 10 years, the S&P 500 Value Index has gained 1.6% per year on an annualized basis, with a standard deviation of 16.6%, while the S&P 500 Growth Index has lost 2.9%, with a standard deviation of 17.7%. There is a great deal of research showing that value stocks outperform, but on the other hand, there is less evidence supporting growth stock investing. While there is a strong consensus on how to define value, there is no such consensus on how to define growth. In fact, the debate is often framed as value versus glamour, where glamour stocks are on the opposite end of the spectrum from value. Glamour stocks are not necessarily going to grow faster, but they are definitely expensive. That is not to say that value stocks will always outperform, and investors looking to minimize their risk or those looking at shorter time periods should probably invest in a core index rather than a style index.

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How Should We Invest Today?
Although growth stocks are typically more expensive than value stocks, over the past 10 years, price earnings multiples for growth stocks have fallen faster than multiples on value stocks. This is explained by the fact that growth stocks started the decade with inflated multiples during the tech bubble and more recently by the decline in forecasts for long-term growth.

Morningstar analysts currently see value stocks as more attractive than growth stocks, with the iShares S&P 500 Value Index (NYSEARCA:IVE) trading at a price/fair value ratio of 0.84, while the iShares S&P 500 Growth Index (NYSEARCA:IVW) trades at 0.94. However, they see the stocks in the S&P 500 Growth as somewhat higher-quality, as 50% of the assets have a wide economic moat, while only 34% of the assets in the S&P 500 Value have a wide moat. Wide-moat stocks have a competitive economic advantage and are able to sustain returns on capital above their cost. It is no surprise, then, that the growth index has more wide-moat firms because these are firms that have the ability to profitably reinvest in their business and grow their earnings.

There are a number of ETFs that focus on the value or growth styles. If you are looking for one fund that covers the entire market-cap range, you might like iShares Russell 3000 Growth (IWZ) or iShares Russell 3000 Value (IWW), which cover nearly the entire equity market and charge just 0.25%. We typically recommend against mixing and matching style funds from different index providers because it can create unnecessary overlap. In the large-cap space, we like Vanguard Growth ETF (NYSEARCA:VUG) and Vanguard Value ETF (NYSEARCA:VTV). Both funds charge 0.15%.

Although the methodologies to define style are similar among the index providers, as we move down the cap range to small caps, the differences become more pronounced. S&P has more-stringent index-inclusion rules that require a firm to show financial viability before being included in the index. Small-cap stocks that do not show a profit tend to be extremely volatile. So, in the small-cap space, we recommend iShares S&P SmallCap 600 Growth (NYSEARCA:IJT) over iShares Russell 2000 Growth (NYSEARCA:IWO). Still, to be fair to Russell, part of the reason the S&P SmallCap 600 Growth has outperformed is that it has less pure growth and more value. The average market cap of a company in the Russell 2000 is also smaller than that of a S&P SmallCap 600 company, also increasing the volatility of the Russell 2000 Index. Both funds charge the same 0.25% expense ratio. Rydex offers ETFs that track the S&P pure style indexes, such as Rydex S&P 500 Pure Growth (NYSEARCA:RPG) and Rydex S&P 500 Pure Value (NYSEARCA:RPV). Despite the lower correlation between the pure style indexes, they have not gained widespread adoption.
