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Written by Luciano Siracusano
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Thursday, 01 January 2009 00:00 |
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Page 1 of 5
 The storied histories of stocks like Microsoft and Cisco—both of which have more than tripled the equity return of the S&P 500 Index since their respective IPOs—have contributed to the allure of growth companies for the past two decades. Unfortunately, identifying which stocks will outperform the market for the next 20 years by similar degrees is a much harder task. Technology changes quickly, and unless companies develop near monopolies within their industry or create a brand that becomes ubiquitous with the service they pioneer, it is exceedingly difficult for firms to maintain competitive dominance.
Thus, many advisors and self-directed investors have abandoned trying to identify the next Microsoft and instead have opted to buy growth stocks through index funds, letting the stocks that rise to the top of such indexes, in effect, answer that question for them.
Risk Without Reward
The problem with this strategy is that growth stocks, as a category, have historically underperformed the broader stock market and have underperformed value stocks, as a category, by even greater margins. When one looks at nearly three decades of risk and return data covering some of the most well-followed growth indexes, it is striking how poorly growth stocks have performed (see Figure 1).
The Russell 1000 Growth Index underperformed the Russell 1000 Value Index by 233 basis points (bps) per year, with approximately 350 bps more annualized volatility, from Jan. 1, 1980, through Sept. 30, 2008. The Russell 1000 Growth Index underperformed the Russell 1000 Index by nearly 140 bps per year, with 251 bps more annualized volatility, over the same time period.
In the small-company and international segments of the market, where the valuation of securities relies more heavily on estimates of uncertain future growth paths, both the growth cuts of the Russell 2000 Index and the MSCI EAFE Index have fared even worse relative to the value cuts of those same core indexes. Both in the U.S. and in the developed world, leading growth indexes over the past quarter-century have consistently been more volatile, yet have not been able to translate greater risk into higher returns.
Although growth stocks have periodically outperformed value stocks, since the inception of the Russell growth and value indexes in 1979, the odds have not favored such an outcome. Figure 2 shows the difference in calendar-year returns between the Russell 3000 Growth Index and the Russell 3000 Value Index since 1980. The Russell 3000 Growth Index has outperformed the Russell 3000 Value Index in only 11 of the 29 years, including the first nine months of 2008. The cycles when growth shined typically coincided with cycles when Technology stocks meaningfully outperformed the U.S. market (1991, 1998, 1999), or when Financial stocks dramatically underperformed the U.S. market (1989-1990 and 2007-2008).
The sub-par performance of traditional growth indexes raises the question, would fundamentally weighted growth indexes have performed any better?
This article will provide a framework for understanding why fundamentally weighted growth indexes may be suitable alternatives for established cap-weighted growth indexes.
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