Skip to Content
ETF Specialist

Fixing Growth Indexes

While most growth indexes have poor long-run track records, a few modifications could make growth-index funds more competitive.

Mentioned: , , , ,

Growth companies are notorious for delivering subpar stock returns over the long run because lofty expectations for future growth are often incorporated into their stock prices. This creates a treadmill effect, where companies must live up to expectations in order to provide an average rate of return. Yet, in forming these expectations, investors tend to extrapolate past growth too far into the future and discount the impact of competition. In order to avoid the expectations treadmill, it is necessary to go beyond consensus growth expectations and high valuation ratios to identify stocks with the potential to enhance value through growth. This has made it challenging to offer attractive passive exposure to growth stocks. Passive value funds hold more than 4 times the assets of their passive growth counterparts. In fact, the  iShares MSCI EAFE Growth Index (EFG) is the only foreign-growth index fund available. The opposite is true in the active universe, where growth funds soak up more than 50% more assets than value funds. 

Growth indexing has come a long way during the past two decades. Prior to the mid-1990s, many value and growth indexes carved up the market solely by valuation, which was used as a proxy for growth. However, high valuations do not always correspond to high growth. For example, a company with low risk should trade at a premium to a comparable company with higher business risk, even when their expected growth is the same. This approach also under-represents companies in asset-intensive industries, which trade at lower multiples of book value than companies with similar growth prospects and fewer assets on the balance sheet. While valuations still play a critical role in nearly all value and growth indexes, most now also incorporate explicit growth forecasts and history as additional selection criteria.

Alex Bryan does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.