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Equity Perspectives

The Russell 1000 Growth Index includes many slow-growth stocks, and overlaps more than half of the S&P 500 Index.

Much ink has been spilled in the active/passive debate, and often the discussion centers on whether investors should pay for active management in a particular investment category. At Lord Abbett, we certainly welcome this debate. We offer growth portfolios across the market capitalization range that historically have dramatically and consistently outperformed their categories and benchmarks. 

But less attention has been paid in the debate to how well a passive approach actually represents an intended investment style. In particular, a look under the hood of the most commonly used large-cap growth benchmark—the Russell 1000 Growth Index—raises a number of questions about the wisdom of employing a passive vehicle in the growth category, bringing to light the benefits of an active approach. These questions also hold implications for the effectiveness of an investor’s asset allocation.

The Russell 1000 Growth Index: A Great Place to Find Slow-Growth/High-Dividend Stocks
Investors have been flocking to passive funds in recent years, in dramatic contrast to their flight away from actively managed funds. As seen in Table 1, the combined net inflow to exchange-traded funds (ETFs) and index funds in the large-cap growth space has amounted to $24 billion over the past five years, while the net outflow from active large-cap growth funds has totaled more than $180 billion. 

 

Table 1. Large-Cap Growth Assets Have Been Shifting Out of Active and into Passive
($ in millions) 

Source: Morningstar. Data as of June 30, 2015.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. The securities and data are for information only. It does not constitute a recommendation or an offer for a particular security, nor should it be taken as a solicitation or recommendation to buy or sell securities or other investments.  
Growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial.

 

Many investors making the switch to passive, however, would be surprised to learn that they are not getting a pure growth investment. The vast majority of these passive vehicles are benchmarked to the Russell 1000 Growth Index, but as Table 2 shows, a look at the index’s 20 largest names reveals a very mixed picture. In fact, 10 of the names in the top 20, accounting for nearly 13% of the index, have dividend yields of more than 2%, and many of these have historical sales growth rates below 5%. Two have actually seen their sales decline in recent years. This certainly does not sound like an effective way to access stocks offering high growth of sales and earnings. 

 

Table 2. The Russell 1000 Growth Index Includes Many Slow-Growth, High-Yielding Companies
Top 20 companies in the Russell 1000 Growth Index, by market capitalization.

Source:  FactSet.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results. The securities and data are for information only. It does not constitute a recommendation or an offer for a particular security, nor should it be taken as a solicitation or recommendation to buy or sell securities or other investments.  

Growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial.
Due to market volatility, the market may not perform in a similar manner in the future.

 

To be fair, Russell is not trying to pull the wool over anybody’s eyes. It is very open about its methodology, which places a large emphasis on the price-to-book ratio (P/B) in defining growth stocks. This methodology, however, produces some unexpected results for investors.

First, because the index is called a “growth” index, many investors believe that all the companies they are buying are generating above-average increases in sales and earnings. (And while calling this benchmark the “High Price-to-Book Index” would be more descriptive, index funds and ETFs with “High P/B” in their name would probably not attract quite the same inflows.)

Second, over the past couple of years, some of the names in the top 20 clearly were in secular decline, but remained in the benchmark until their price-to-book ratio finally fell enough for them to qualify as value stocks by Russell’s definition. Names such as Philip Morris and McDonald’s, for example, have experienced declining earnings in recent years, but it was not until 2014 that they finally fell out of the Russell 1000 Growth’s top 20. That could be a negative surprise for index investors expecting high revenue and earnings growth, and it’s indicative of the pitfalls of passive growth investing.

Needless to say, given this problem, investors will wind up owning many stocks that fail to offer high growth of sales and earnings. What’s more, this may result in a doubling-up on value and core stocks across their overall portfolio, spelling even more trouble for their asset allocations.

An Expensive Lunch: Why Indexing Your Growth Allocation May Reduce Your Diversification
When Harry Markowitz famously stated that diversification was the only “free lunch” in investing, he certainly meant diversifying with different securities, not different funds holding the same ones! Chart 1 shows just how much overlap exists between the Russell 1000 Growth Index and another major index, the S&P 500. Over the past five years, this figure has remained above 50%. Considering that the Russell 1000 Growth Index includes many stocks that would be perceived by many investors as core and value stocks, it becomes clear that owning the index could undermine an investor’s efforts to diversify risk.

 

Chart 1. The Russell 1000 Growth Index Overlaps Substantially with Broad Market Indexes
Percentage overlap between the Russell Growth Index and the S&P 500 Index.

Source: Factset. Data as of June 30, 2015. Represents security overlap between the two indexes by index weight.
The historical data are for illustrative purposes only, do not represent the performance of any Lord Abbett mutual fund or any particular investment, and are not intended to predict or depict future results.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

 

The growth of ETFs and passive index funds has surged in a number of equity segments since the financial crisis of 2008–09. For active sector traders or for an asset class that is proven to be highly efficient, there is perhaps an argument to be made for using these vehicles. However, in the large-cap growth space, there is clear evidence that not only is indexing a poor means to access growth stocks but it may also create meaningful risks to an investor’s asset allocation. With growth stocks experiencing a period of significant relative outperformance of the overall market, we believe investors who are looking to access this asset class should instead seek a manager with a focus on true high-growth companies and whose holdings are distinct from core and value segments of the market. 

 

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