A compelling U.S. mid-cap growth ETF

This fund's low-fee, turnover-conscious approach to portfolio construction, and its broad diversification, should serve investors well.

Alex Bryan 17 April, 2018 | 5:00PM
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While most mid-cap growth stocks don't attract as much attention as their larger counterparts, they tend to offer greater growth potential, with a little less risk than small caps. Among the U.S.-traded ETFs that invest in this segment,   Vanguard Mid-Cap Growth ETF (VOT) is one of the most compelling because it is one of the cheapest. On top of its considerable cost advantage, the fund effectively diversifies risk and applies generous buffering rules to mitigate unnecessary turnover. It earns a Morningstar Analyst Rating of Silver.

The fund employs full replication to track the CRSP U.S. Mid Cap Growth Index, which targets stocks representing the faster-growing and more richly valued half of the U.S. mid-cap market and weights them by market capitalization. These firms have attractive outlooks, but there is always a risk that they won't live up to the market's expectations. Many of the fund's holdings have not yet established sustainable competitive advantages and may not hold up as well as large caps during market downturns.

Because it casts a wide net, this portfolio includes some stocks with only modest growth traits. These holdings should help reduce volatility by limiting exposure to the most-speculative stocks. Despite its broad reach, the fund has less overlap with its value counterpart,  Vanguard Mid-Cap Value ETF (VOE), than do rival value and growth funds based on the Russell Midcap and S&P MidCap 400 indexes. Its benchmark also applies more-generous buffer rules to mitigate turnover.

Low turnover helps mitigate the fund's transaction costs. To further reduce these costs, the fund's index only moves half of each position into or out of the portfolio at a time. And in September 2017, the fund started to spread its rebalancing trades over five days, so that it doesn't move prices as much as it previously did when it concentrated all the trades on one day.

Vanguard charges a razor-thin 0.07% expense ratio for this offering, making it one of the cheapest options among U.S. small/mid cap ETFs. During the trailing three years through March 2018, the fund lagged its benchmark by 5 basis points annually, less than the amount of its expense ratio. This was due to securities-lending revenue. The style orientation and industry composition of this portfolio are often similar to that of its average peer, but its low fee gives it a sustainable edge.

Fundamental view

High growth doesn't necessarily translate into high returns. For that to happen, firms must exceed the growth expectations already embedded in their stock prices. That can be a tall order for the fund's holdings because their high valuations suggest that investors have high expectations for them. Mid-cap growth companies tend to have greater growth potential than their larger counterparts. But they also tend to be more volatile and could be more prone to mispricing, as fewer analysts cover these firms.

While some of the fund's holdings may exceed expectations, there is always a risk that investors may be overly optimistic about these firms' growth prospects. Strong growth attracts competition, both from established firms seeking to preserve their market share, and new entrants, which can make it difficult to sustain. Disruptive innovation from a competitor can also derail growth.

Even when it is sustainable, growth is not always in investors' interests. Growth should be judged against the investments required to generate it. In some cases, investors could earn higher rates of return if the firm returned the cash rather than investing for growth. The fund penalizes firms for undisciplined (low-return) growth by incorporating return on assets into its selection criteria. However, this metric has only a small influence on the portfolio.

All of this may explain why value stocks have historically outpaced their growth counterparts in nearly every market studied over the very long term. That said, mid-cap growth stocks will go through inevitable stretches of strong and weak performance relative to the broader market, which are difficult to forecast. This fund is one of the best options for exposure to this area of the market.

The fund's broad reach and market-cap-weighted approach help diversify risk and limit its exposure to the riskiest growth stocks. That's important because there is no limit on the price the fund will pay for its holdings. The portfolio includes more than 150 holdings, such as medical information management leader Cerner (CERN), Moody's (MCO), and Dollar Tree(DLTR). The top 10 holdings represent only 14% of the portfolio.

Because the fund does not adjust for differences in industry growth rates, it tends to have persistent overweightings in certain sectors like technology and healthcare, and underweightings in others like utilities and financial services. Other U.S. mid-cap growth ETFs have similar sector tilts, but this fund has greater exposure to consumer cyclical stocks and less exposure to the financial-services sector.

Market-cap weighting promotes low turnover and reflects the market's view about the relative value of each stock. It also skews the portfolio toward the largest mid-cap growth stocks, which may not be the fastest growing or have the highest expected returns. However, the fund's holdings have a market-cap and growth orientation similar to the category average. The fund's style-buffering rules allow stocks with slowing growth to stay in the portfolio after they drift slightly outside of mid-cap growth territory, but that is a reasonable trade-off for lower turnover.

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About Author

Alex Bryan

Alex Bryan  Alex Bryan, CFA, is director of passive strategies for North America at Morningstar. Before assuming his current role in 2016, he spent four years as an analyst covering equity strategies. He holds an MBA with high honors from the University of Chicago Booth School of Business.

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