Maximizing Returns With Active ETFs in Growth Stocks

This is particularly true across the growth stocks.

Today, growth managers using the ETF structure are quickly beating their passive rivals with strong returns. Going forward, active ETFs in the growth space could be the best way to build portfolios of the factor type and provide plenty of future returns.

Two of the earliest factors that many investors have focused on remain “value” and “growth.” There are many ways to define these broad categories of equities, but growth stocks generally are seen as a firm that is anticipated to grow — usually via revenues — at a rate significantly above the average growth for the market or its sector. So, if stock XYZ is expected to see revenue growth of 20% per year and the broader S&P 500 is only expected to see about 5%, then the stock would be considered a growth stock. Some more mature firms are seen as growth stocks because they are able to generate their profits at a faster rate than the overall market.

Historically, growth stocks tend to fall in the tech, healthcare or consumer discretionary sectors. Here innovation, new products and consumer popularity tend to drive sales at rates faster than sector or market averages.

The nature of growth stocks themselves often feature higher valuations than value or blend stock indexes. Investors are willing to pay for higher valuations when surging revenue growth is anticipated. Moreover, many growth stocks aren’t yet — or are only barely — profitable, and therefore, put retained cash flows back into the business. As a result, they don’t often pay dividends, as much of their returns come from capital gains.

Over the last decade or so, investors have taken to growth in a big way. Driven by innovation and technology returns, growth has managed to crush value and the broader index by a large margin.

And in those returns, active may have an advantage. Active management of sectors and asset classes works best when managers are able to exploit pockets of market inefficiencies. This is true with regards to growth. Managers can do the groundwork, find those firms that are growing fast, seek out the game-changing technologies or drugs, and land on some durable businesses among these stocks.

Just take a look at the number of articles that are published on Apple every day. It’s hard to find any new formation that the market hasn’t already seen. But for firms with less weighting in a growth index, this isn’t the case. Active managers can win.

And data supports this idea.

A whitepaper from Harbor Capital showcases concentrations of the Russell 1000 Growth Index with future returns. As investors have embraced the Magnificent Seven and ultra-large-cap technology stocks, the concentration of the Russell has surged. Over the last decade, the weighting of the index’s top-ten holdings has increased from 21.6% to 51.3%. ¹

Source: Harbor Capital

The above chart shows that when there is less meaningful index concentration, active manager performance increases. Harbor suggests that two factors are in play with this and helps to explain how active managers can win in growth over indexes.

For starters, this includes the unwinding of these large positions as growth finally slows in the top holdings. As they do, top holdings in the growth indexes tend to fall hard. The steadier performance of other growth stocks lower within the index provides a better path of consistent performance. Active managers can seek out these firms and not be so top heavy in their holdings. This provides a better overall performance.

Secondly, during times of duress and lower economic growth, active managers can find opportunities among the so-called scarcity of growth. This helps them to perform better during economically difficult times.

So, active growth managers can perform better over full market cycles than indexes. ETFs make this performance even better — and that’s because ETFs win on two fronts (taxes and costs) versus other fund structures.

Growth managers tend to focus a lot on trading and capital gains-oriented returns. Frequent buying and selling generates a lot of taxes, often at high short-term gains rates that can eclipse 36%.

Thanks to the creation-redemption mechanism, authorized participants and the secondary market, ETFs are able to limit gains for their investors. This helps enhance after-tax returns versus mutual funds and other investment structures.

Secondly, ETFs are lower cost than other fund vehicles. Investing in innovation and smaller firms often takes plenty of “boots on the ground” research, directly talking with company management, and in the field trend-watching — both of which cost plenty of money. With less being spent on actual fund management, active managers can spend the same or more on these efforts. The overall lower expense ratio and extra research spending can provide a meaningful lift to returns.

With that in mind, using active ETFs to get growth exposure is good practice. Ultimately, investors will be able to realize better returns than indexes for a full market cycle.

These ETFs are sorted by their YTD total return, which ranges from 11.2% to 21.3%. They have AUM between $595M and $12B and have expenses between 0.12% and 0.59%. They are currently yielding between 0% and 9.5%.

In the end, growth stocks can offer high rates of returns for investors, and they have been outperforming other factors for some time now. The best way to exploit these returns is through active management — and ETFs are the best way to do just that.

Active management tends to work in sector and market segments in which managers can exploit inefficacies. This is true for growth stocks. ETFs have only enhanced this fact further, offering strong returns, low taxes and better outcomes for portfolios.

¹ Harbor Capital (February 2024). U.S. Large Cap Growth Equities