Stock Growth Funds Are Back. Here's How To Pick The Right One.

During the past year, growth fund investors have fled to safer and cheaper value stocks due to rising inflation and interest rates. After declining for most of this year, the group has been making a comeback as the economy slows down and the Federal Reserve begins to taper off its interest-rate increases.

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The best bet is to pick a fund that has a good return.

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Many investors thought the Fed still had a long way to go before it quells soaring inflation after January's strong jobs report. As the financial system recovered from Silicon Valley Bank's collapse in March, many are now wondering whether the central bank has gone too far and whether the nation's financial system can endure another collapse. In terms of expected interest rate cuts by the end of the year, traders are projecting a 98% probability.

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Investors would shift their money from the bond market to higher-risk, higher-return investments if interest rates were stable or even loosening since a stable environment would result in higher returns for growth companies. Companies can also raise money and expand their business more easily when borrowing costs are lower.

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The move has already started to be made by some investors. A total of $3.8 billion in new assets were added to U.S. exchange-traded funds that focus on large-cap growth stocks in March, while a similar amount of assets were lost to exchange-traded funds that focus on large-cap value stocks.

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Nearly a third of its value had been lost by the end of last year after the Russell 1000 GrowthIWF +0.56% ETF (ticker: IWF) peaked on November 20, 2021. As a result of this, the fund gained 14% in the first quarter of 2023, nearly double the return of the S&P 500SPX +0.34% index for the same period.

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There is even more interest in stocks of larger growth companies. ETFs such as Schwab U.S. Large-Cap Growth (SCHG) and Vanguard Mega Cap GrowthMGK +0.70% (MGK) gained 17% and 19%, respectively, in the first quarter. FactSet calculates that each fund's weighted average market cap is more than $850 billion.

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While their valuations are much lower, small-cap growth funds have lagged behind. The iShares S&P Small-Cap 600 Growth ETF (IJT) and the Invesco S&P Small-Cap 600 Pure Growth ETF (RZG) gained less than 2% in the first quarter.

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A hard landing still seems likely after the Fed tightens its monetary policy. Due to their limited resources, small companies have a difficult time surviving recessions.

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Investing in index-based ETFs that aim to provide growth exposure, however, requires caution. Since market dynamics have dramatically changed over the past year, some growth funds might no longer hold stocks that were considered growth stocks 10 years ago.

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Companies such as Alphabet (GOOGL) and Amazon.com (AMZN) have long been considered poster children for growth. The S&P Dow Jones Indices has reshuffled its definition of "pure growth" stocks, however. With the Fed raising rates aggressively during the pandemic, the group has had difficulty maintaining high growth rates.

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A number of fossil-fuel giants, including Exxon Mobil (XOM) and Chevron (CVX), have noticed their fortunes changing over the last few years. Russia's yearlong military operation in Ukraine triggered a global energy crisis, which caused oil and gas prices to soar. Energy companies made record profits as a result. In the last year, some companies have moved from value to growth territory, where they had spent more than a decade.

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Growth ETFs are therefore worth a closer look under the hood. Due to different rebalancing schedules and stock-picking standards, today's holdings could differ significantly from those in the past.

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The Invesco S&P 500 Pure Growth fund (RPG) has 28% of its investments in energy stocks and only 14% in technology stocks, while the iShares S&P 500 Growth fund (IVW) has 34% of its investments in technology stocks and just 8% in energy stocks. With over half of its holdings in technology and less than 1% in energy, Vanguard Mega Cap Growth has a significant presence in the former, whereas First Trust Large Cap Growth AlphaDEX (FTC) has a substantial presence in the latter.

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The most common investment strategy is actively managed funds with stocks handpicked by a portfolio manager rather than index funds driven by mathematical rules. Portfolio managers have a unique perspective on companies that cannot be accessed by algorithms.

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Morningstar director of manager research Russel Kinnel says choosing an active growth fund requires separating managers who research deeply for long-term performance from those who just utter buzzwords about trends and technology.

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In order to invest effectively, Kinnel recommends tuning out short-term performance. The best time to buy a really good investor with an out-of-favor portfolio is often when it is out of favor. He looks for funds with strong long-term records that will underperform in 2022.

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Regardless of how smart the fund manager sounds, Kinnel says investors should never pay high-flying fees. Vanguard International Growth (VWIGX), Harbor Capital Appreciation (HCAIX), and T. Rowe Price Blue Chip Growth (TRBCX) are three moderately priced mutual funds that have ranked in the top third among their peers for the past 15 years but are forecast to fall to the bottom 20% in 2022.

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In light of all the uncertainties in the market, the growth rebound may not commence immediately, and investors should prepare themselves for further ups and downs as time goes by. It will be sufficient for you to get a nice return over the next ten years if the stocks are beaten down,” Kinnel advises. “I’m not too concerned after the blowout year that we experienced last year,” he says. “The real risk is buying at the peak.”

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