A Razor-Thin Fee Gives This Growth ETF an Edge

In January 2017, BlackRock switched the fund's benchmark to the S&P 900 Growth Index from the Russell 3000 Growth Index, which effectively removed its small-cap holdings. This change was motivated by client requests to carve out small caps and BlackRock's desire to align the fund with the broader suite of iShares "core" branded U.S. equity products, which use S&P indexes. Along with this change, BlackRock cut the fund's fee to 0.05% from 0.07% and absorbed the resulting trading costs.

The new index provides very similar exposure to the Russell 1000 Growth Index. In fact, more than 85% of their assets overlap, so they track each other closely. Like the Russell index, the fund's new benchmark targets U.S. large- and mid-cap stocks representing the faster-growing and more richly valued half of their market segment. This sweeps in more than 500 holdings, which the fund weights by market capitalization, pulling it toward giant firms such as

Unlike most indexes, the fund's parent index, the S&P 900, is maintained by a committee rather than a set of mechanical rules. It also requires new constituents to have positive net income over the previous four quarters, which introduces a slight quality tilt. Despite these differences, the composition of this portfolio is similar to its index peers.

The fund has performed well over the long term. It beat the large-growth category average by 1.66 percentage points annually over the trailing 10 years through January 2017, with comparable volatility. This was partially due to its durable cost advantage.

Fundamental View The fund's holdings enjoy many attractive attributes. They tend to have better earnings-growth prospects and profitability (reflected in their higher average return on invested capital) and are more likely to sport durable competitive advantages than their value counterparts. These characteristics are reflected in their higher valuations. As a result, growth stocks are not necessarily better investments than value stocks. From its inception in December 1978 through January 2017, the Russell 1000 Growth Index (which offers similar exposure to this fund) actually lagged the Russell 1000 Value Index by 1.2 percentage points annualized. What matters is realized growth relative to expectations, which is hard to forecast.

There is a risk that investors may become overly optimistic about the growth prospects of the fund's holdings and extrapolate past growth too far into the future. A company can only grow faster than its industry by taking market share away from its competitors. But growth encourages imitation, and rival firms tend to react aggressively to preserve their market share. Growth also becomes more difficult to sustain as a firm becomes larger. The fund eventually jettisons holdings that drift out of the growth style zone, but these stocks can remain in the portfolio long after their growth has started to slow.

Disruptive innovation is a strong driver of growth. For example, Amazon.com,

Even when it is sustainable, growth is not always beneficial to shareholders. Manager compensation is positively correlated with firm size. Therefore, managers may be tempted to undertake risky and low-return projects to expand the business at shareholders' expense. The fund's broad reach and market-cap-weighting approach may help mitigate some of these risks.

This is a well-diversified portfolio that includes more than 500 stocks, the top 10 of which represent just over a fourth of its assets. Market-cap weighting tilts the portfolio toward the largest growth stocks, which are not necessarily the fastest-growing. Most of the fund's sector weightings are similar to the category norm, but it has a smaller stake in the financial-services sector and greater exposure to the technology sector. Like most of its peers, the fund favors stocks in the healthcare, technology, and consumer cyclical sectors. The fund does not make any sector-relative adjustments to its selection criteria, and there are no constraints on sector weightings or valuations. Yet, at the end of January 2017, its holdings were trading at an average multiple of forward earnings comparable to the category average.

Portfolio Construction The fund employs full replication to track the market-cap-weighted S&P 900 Growth Index. This benchmark effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting the Positive Process Pillar rating.

The selection process begins with the stocks in the S&P 900, which combines the large-cap-focused S&P 500 and S&P MidCap 400. S&P assigns composite growth and value scores to each stock in the S&P 900 using three growth metrics (12-month price momentum and the three-year change in earnings and sales per share) and three value metrics (price/book, price/sales, and price/earnings). It then ranks each stock by the ratio of its growth score to its value score. When a stock falls in the most value- or growth-oriented third of the S&P 900, S&P fully allocates it to the value or growth index, respectively. S&P partially allocates stocks that do not exhibit a clear style to both indexes, so there is considerable overlap between the two. They each represent about half the assets in the S&P 900 and are rebalanced annually in December. The fund's market-cap-weighting approach helps mitigate turnover, which should translate into lower transaction costs.

Fees At the same time as the index change in January 2017, BlackRock cut the fund's fee to 0.05% from 0.07%. This expense ratio is among the lowest in the category, supporting the Positive Price Pillar rating. The managers generate ancillary income for the fund through securities lending, which helps offset its expenses.

Alternatives

A momentum fund, such as

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