When you first start looking for mutual funds to buy for your IRA or another investment account, you quickly discover that the number and variety of fund types can be pretty bewildering. But digging into the subject a little further, you'll see that a majority of funds can be classified as either growth funds or value funds. When you're shopping for an appropriate fund for your portfolio, understanding the difference between these two fund types is important.
First, a Little Background Info
Before getting into the difference between these two fund types, you'll need a little background information. When you buy a mutual fund (or an ETF, which behaves pretty much the same way as a mutual fund), you're buying a big basket of individual stocks preselected by a mutual fund manager.
For instance, when you buy Fidelity New Millennium Fund (symbol FMLIX) you're buying a basket of 173 different stocks in 10 different enterprise categories such as finance, healthcare, energy and telecommunication services. the idea underlying the selection is to reduce the risk of a sharp decline in any one stock with a portfolio of many different stocks in several different categories. This is a standard strategy for all but the most specialized mutual funds, and fulfills the goal of one of the most important investment strategies, diversification.
The opposite of diversification is concentration. If you bought only a single stock for your entire portfolio, say Boeing, you'd have concentrated all your investment funds in a a single field, aerospace, and within that field a single company. Boeing has been a reliably profitable company for many decades, but buying that one stock for entire portfolio is as undiversified as investing gets. If for some reason, however unlikely, Boeing ran into financial difficulties, you would lose a major portion of your investment.
One way to achieve diversification would be to buy a whole lot of different stocks in a variety of areas: healthcare, retail, finance, information technology and more. But unless you've got a lot of money, that's not a particularly efficient way to go because you'll probably run out of money before you can buy as many individual stocks as real diversification requires. Even if you could manage to buy one stock in each of 100 companies, you're going to be paying a separate brokerage transaction fee on each of them, which definitely adds up.
Instead, you buy a mutual fund, where the work of diversification has been done for you by the fund's manager. The core idea of a mutual fund, where Boeing, for example, might only be 2 or 3 percent of the fund's holdings, is that while, yes, companies do fail, most companies don't and if your investment includes a lot of companies in different investment areas, it's unlikely they'll all fail together.
Other Mutual Fund Strategies
The fund manager for the New Millennium Fund is John Ruth, who works for Fidelity, a huge financial management company with almost two trillion dollars worth of equities under management.
Underlying Ruth's strategies for buying the 173 stocks in the New Millennium fund are a few important criteria. One, previously noted, is buying stocks in many different enterprise areas. Another is buying stocks according to the size of the company.
New Millennium is classified as a "Large Cap Growth Fund," meaning that so far as Cap size goes – Cap being short for "capitalization" – Ruth tends to buy big companies, although not exclusively. As Ruth explains, his strategy is to consider "other factors – which can lead to investments in small and medium-sized companies." Even so, because the fund primarily buys big companies, the fund is classified as a Large Cap fund, or to put it in everyday language, a fund that primarily buys companies worth a whole lot of money – companies that by definition are worth $10 billion or more.
What "Growth" Means
As the manager of a growth fund, it's Ruth's job to identify companies that he believes will outperform the market. When the prospectus (a kind of explanatory sales blurb) of a growth fund explains that it "seeks capital appreciation," that what it really means. While the underlying assumption of the stock market is that over the long term the market itself will rise in value, a growth fund is expected to grow in value even faster – to "outperform the market."
This need to outperform also explains why even though the Fidelity New Millennium is designed to be a Growth Fund, Ruth sometimes invests in smaller companies. The best-run smaller companies (Small Caps) generally rise faster than well-run Large Caps, even though overall small companies fail more often. That's where a mutual fund manager's skills come into play. If he can identify those smaller companies that are destined to grow faster than the market (and, needless to say, aren't destined to fail), then he'll have "outperformed the market." And that's the very definition of a growth fund - a fund with a portfolio of stocks that perform better than the market average.
Even though brokerages frequently advertise that with their superior research skills and stock-picking experience they can provide an investor with a stock portfolio that outperforms the market, the idea that anyone can outperform the market over the long term isn't an agreed upon economic concept. In fact, a lot of well-researched academic studies have concluded that over the long run, the likelihood of a a portfolio beating the market is no better than chance!
While not all economists agree with this conclusion, a growing number do. So, if you can't beat the market by buying a portfolio of outperforming stocks – which is the underlying premise of a growth stock fund, what can you do?
One thing you can do is give up the entirely the notion of doing better than the market. Instead, you buy Index Funds - funds that try to match as closely as possible the holdings of some large market segment, like the S&P 500, or even the entire market, so-called total market index funds, such as the Vanguard Total Stock Total Market Fund (VTSMX).
This is the theoretical extreme of diversification and reduces your risk even further than other mutual funds because for over 100 years the average annual return in the stock market has exceeded nine percent. By giving up the attempt to beat the market, you participate with near certainty in that nine percent long-run average annual market return.
There's another way of putting together a stock portfolio, which is the underlyingconcept of Value Funds. A Value Fund is a mutual fund with a portfolio of stocks undervalued by the market - the ugly ducklings of finance. The world's best known value investor is Warren Buffett, who has become a multibillionaire buying stocks in companies that the investment world had written off as losers.
Buffett's mentor in value investing is Benjamin Graham, who formed these seven underlying principles of value investing:
- Buy stocks with decent ratings, not great ratings: the B+ stocks of the investment world. These are the stocks of fundamentally sound companies with business plans that excite no one.
- Among these unexciting companies, look for ones that don't have a lot of debt - a debt to current asset ratio of no more than 1.10.
- Look for companies with a current ratio of 1.5 or better – the current ratio is the ratio of a companies total assets to total current liabilities and is a good indicator of a company's ability to survive an economic crunch.
- Only buy stocks of companies that have had profits every year for the most recent five years of operation. Consistency isn't exciting, but it's an essential characteristic of successful companies.
- Buy stocks of companies with low ratios of share price to annual earnings - preferably 9.0 or better. These companies provide more value for the money.
- Look for stocks selling for less than book value. The price to book value ratio equals current share price to book value. Book value is the value of the company's total assets less its intangible assets (such things as good will and patents)
- Buy companies with a consistent record of dividend payments to stockholders. Another way of valuing consistency and recognizing its importance for economic survival.
These seven characteristics of a Value stock are fairly technical in nature and it's not necessary to fully understand them to buy mutual funds with portfolios conforming to these principles. That's the fund manager's job. It's enough for you to know that
- the stock market is not fully rational and stock prices are determined as much by investor sentiment as by objective valuations of worth - bargains exist
- using these seven criteria an experienced fund manager can unearth these undervalued stocks to construct his Value Fund portfolio
Which is Better: Growth or Value?
This seems as if it might be one of those unanswerable questions, but a lot of recent economic research points to these interesting results:
- The most spectacular outperforming stocks, as you might guess, are all growth stocks – Apple, for example – but they're outliers.
- By and large, Value Funds tend to outperform Growth Funds except in a particular part of the stock market cycle
- Early in a stock-market recovery - the period that follows a bear market - growth funds outperform value funds, particularly in the first two years of a recovery period.
- In bear markets, Growth Funds generally underperform Value Funds by a significant margin.