Value and growth index funds have traditionally acted as targeted investment options for many investors. However, these traditional style indices may not offer the same benefits as factor-based, smart beta exchange traded funds.
“Traditional style indexes may not offer pure exposure to value and growth stocks because they often must account for an entire stock universe,” Fidelity Investment strategists, led by Darby Nielson, said in a research note.
The Fidelity team explained that the style indices that many are acquainted with were designed to cover an entire universe of stocks across the value/growth spectrum and classify them as one or the other, and even both in some cases. These traditional indices may be comprised of inexpensive stocks that appear to be growing quickly, or stocks within a value style index may not truly be inexpensive but have weak earnings.
For example, Apple (NasdaqGS: AAPL), which is traditionally defined as a growth stock, makes up about 5.5% of the widely observed Russell 1000 Growth Index and still make up 0.48% of the Russell 1000 Value Index. These traditional style indices would have a large tilt toward their specific growth or value styles, but they may still include some residual exposure to the other style.
“It is better for investors to rethink the value definition and how you get value exposure,” Matthew Horne, Director of Sector and ETF Investment Strategy at Fidelity Investments, said in a call with ETF Trends.
For example, a factor-based value strategy would specifically screen for value by identifying companies trading at low price-to-earnings ratios and exclude those aren’t. Through a targeted definition of value to capture stocks, investors will hone in on a the segment of the market that is truly trading at a discount. It is also important for investors to understand a factor-based indexing methodology since various providers would have varying definitions, including earnings, book-to-price, sales or cash flow, which may affect performance.
Additionally, momentum investing can target those companies that are exhibiting high levels of growth. The momentum factor selects company stocks that have recently outperformed based on the idea that “the trend is your friend” and that stock market leaders typically continue to outperform. This type of strategy can be an effective way for targeting growth-oriented companies since stocks with positive momentum often continue to generate strong earnings.
As we consider value and growth factor-based options, investors may also think about combining the two into a diversified portfolio.
“When combined, value and momentum factor strategies have the potential to provide more diversification than a combination of traditional value and growth style indexes, which simply offers broad-market exposure,” according to the Fidelity strategists.
While traditional value and growth style indices have traditionally shown a negative correlation, value and momentum factor strategies have a lower average historical correlation so they don’t offset one another, which should help the factors enhance diversification within an investment portfolio.
ETF investors interested in these two factors have a number of factor-specific, smart beta options available, such as the Fidelity Momentum Factor ETF (NYSEArca: FDMO) and Fidelity Value Factor ETF (NYSEArca: FVAL).
The line of Fidelity factor based ETFs can help investors achieve strategic and cyclical exposure, along with filling out an investment portfolio construction. By incorporating the various factor based ETFs into an investment portfolio, investors may be better able to diminish risks and still capture any upside potential.