We’ve got small-cap value covered with AVUV, but what should we pair it with? In this deep dive, I look at what large-cap growth fund might work best in concert with AVUV. The candidates are VOO, VUG, IVW and DFUS - with VUG and IVW achieving exalted (ha!) status of “preferred asset.”
Risk Parity portfolios often tend to focus on asset classes other than equities. This is expected: lots of people already cover equities, and RP is known for what else you add to equities to balance out risk, so there is more discussion on the alternatives beyond the usual. But still, we shouldn’t lose sight of the fact that equities are likely to be the dominant source of returns in your portfolio, most of the time.
Following up on the recent post about small-cap value funds, I'm a big fan of weighting in that direction but I didn’t get into what you can pair such funds with, namely funds which are opposite in two ways: made up of large companies, not small, and oriented towards growth companies, not value. Assuming small-cap value is part of your portfolio, what is the preferred way to invest in large-cap growth stocks?
This assumes a two-part equity strategy, and a focus on US equities only. Neither of these assumptions should be taken as limitations; in the future, I’ll expand the discussion to include international equities as well as other approaches to equities beyond simple factors like size and value.
But for now, I think of this two-part strategy as a “tortoise and the hare” approach, where small-cap value is the tortoise that should win at the end, but for most of the race, it will be this large-cap growth hare which sets the pace. Having both can be a benefit over having just one fund, as a lower degree of correlation between the two should provide a boost when rebalancing. I can take some energy from the hare when it is racing ahead to give some oomph to the tortoise, and can use the tortoise’s persistence to awaken the slumbering hare.
The Candidates
VOO
Vanguard S&P 500 ETF. Fund page, Barchart Summary. The ol’ standby, and included as a baseline test. Just tracks the S&P 500 Index, making this as low-frills as you can get. Feel free to substitute in the slightly more expensive SPY (expense ratio of .09%) or IVV - they are all pretty much the same.
VUG
Vanguard Growth ETF. Fund page, Barchart Summary. Essentially, a more growth-tilted version of the S&P 500, which is already tilted towards large-cap growth, of course. Tracks the CRSP US Large-cap Growth Index. Technically, this is not exclusively a large-cap fund, but only 12.4% of holdings are mid-cap or lower. If you want large-cap only, Vanguard’s VOOG would work, too.
IVW
iShares S&P 500 Pure Growth ETF. Fund page, Barchart Summary. Tracks the S&P 500 Pure Growth index, which is formed by applying a growth/value screen to the S&P 500 and then focusing exclusively on constituent stocks with the highest growth scores. Invesco’s S&P 500 Pure Growth ETF (RPG) is a similar ETF that tracks the same index, but has a higher expense ratio.
DFUS
Dimensional US Equity ETF. Fund page, Barchart Summary. This is an active fund, albeit a systematic one with a low expense ratio, that uses the Russell 3000 as its benchmark. I included this fund to see if an active strategy might be better than the passive ones. It is more of a large-cap blend fund than growth, and has a particularly short history: just launched in June, 2021. Prior to that it was the mutual fund DTMEX, though I don’t have a way to backtest that fund. The DFA fund that would have been best is DUSLX, their Large-cap Growth fund, but this is still only in mutual fund form and only available through an advisor. If this becomes an ETF, it would definitely deserve consideration.
How Will I Decide?
To start with, I’ll lay out the evaluative criteria. What exactly am I looking for?
- I want as much diversification from other equity funds as I can get, especially from small-cap value. I’ll also put in international stocks, just to see.
- I’m looking for it to contain the largest, biggest US companies. If I wanted my small-cap value to be the most “small-cap value-y,” then I want this to be the most large-cap growth-y. I’ll look for it to track a narrower index that focuses on large-cap companies, and to have higher valuation ratios, suggesting market expectations for growth.
- Above all, performance is key. I suspect this asset will be volatile, and I suspect it will underperform funds like small-cap value over the long-term. In the shorter-term, though, I want to find a fund that when it is booming, is really booming. I am looking for high returns over long time frames, with high capture of market upside.
First Criterion: Diversification from Other Equity Funds
The idea behind combining small-cap value and large-cap growth is sometimes known as the “barbell” approach where you have large allocations to the aspect of the US market that are most diverse from each other. These are the two slices of the market most likely to have large gains, but ideally, I’d like them to have their gains at different times and with different rhythms. In the decumulation stage, I’d like to always have one that is pressing ahead, and in the accumulation phase, I can benefit by rebalancing from the leader to the laggard.
As usual, the key here is correlation, and again I used Portfolio Visualizer’s Asset Correlation tool to compare the four candidates with international equities (in this case, VGTSX for VOO, VUG and IVW, then VXUS for the younger DFUS). I don’t expect for these funds to have much diversification compared to international equities, as those funds are often full of large-cap equities but perhaps with more of a blend of even value orientation. Still, I just wanted to check.
None of these are all that diversified from international stocks or from small-cap value, but there is a slight fork forming between VOO and DFUS on the one side, and VUG and IVW on the other. Again, not a big difference, but slightly lower correlation for the ones with an explicit goal of growth. Score this a tie for first between VUG and IVW.
Second Criterion: Seeking a low-cost, broad-based Index Fund
These are all pretty straight-forward. The percentage in large-cap and weighted market cap give us a sense of how large-cap each fund is, and weighted price-to-earnings and price-to-book ratios gives us a sense of how the market views the constituent companies in the funds.
Another split here, though this time three against one. DFUS is an outlier in having less in large-cap, but a figure of 89.3% still keeps it as a large-cap ETF in my eyes. The most large-cap-y in these metrics is IVW by a hair over VUG. In terms of most growth-y, it is VUG with a slight edge over IVW. As an investor with a natural tendency to seek out low P/E ratios, it is weird to think of a P/E over 30 as “better” than its competitors, but in the particular logic of this analysis, VUG seems to give you more of what you are asking for if you want a complement to an existing allocation in value.
Third (and most important) Criterion: Performance
The choice for this fund breaks some of the rules I follow elsewhere. For one, I am convinced by the evidence behind factor investing, and endorse the idea that long-term, small-cap value will outperform its inverse. Yet here I am, choosing the ETF that departs farthest from that. I looked at the factor regression analysis from Portfolio Optimizer as I was researching, and faced a bit of a conundrum: should I look for the fund with the worst metrics for exposure to what causes equities to out-perform?
Secondly, usually I’m all about looking beyond simple returns numbers and instead look at a fund’s volatility profile and Sharpe ratio. Yet for large-cap growth, here I am eschewing those in favor of raw returns, plain and simple. I have three different timeframes for tracking CAGR, but do keep in mind that the 2010s were an extraordinarily great decade for large-cap growth stocks. I’d say that these mark the high water mark for performance, not a typical return going forward.
I also included two other stats to consider: 1) the annualized alpha should give us a sense of what else these funds are doing beyond just adding market risk, and 2) upside capture ratio, which measures how much the fund has outperformed the benchmarks in up markets. In the portfolio, I’m looking for this asset class to take advantage of good times and drag the portfolio forward, and this is my indicator. For both, higher is better.
Looks like pretty much a tie again between VUG and IVW. IVW has the slightest of edge in terms of CAGR, though paradoxically, I am wondering if VUG’s worse performance over the past 14 months indicates it actually does more of what I want it to do - boom in good times. It’s been a bad period lately, and my expectation is that it would take a dive. The fact that VOO, for one, hasn’t might be an indication that it is not fully dedicated to the cause.
IVW also has a slight edge in terms of annualized alpha, but then VUG is marginally better in terms of upside capture. Meanwhile, VOO just kind of hums along, with good measures, but nothing outstanding. DFUS just doesn’t have the track record that would allow me to assess it. I’m seeing that VOO and DFUS may belong to another category - the equity fund when (for some reason) you only can or want to use one fund.
I ran other tests of Monte Carlo simulations and different backtests of the candidates in various portfolios, and combined with a small-cap value, but they all came to basically the same conclusion: there isn’t much difference between VUG and IVW, but both are better than VOO and DFUS doesn’t have the track record. I had planned to include these, but there isn’t much point. If you’re curious, though, here is a look back to 2000, using the mutual funds that became VOO and VUG.
So, After All That…What’s the Preferred Asset for US Large-cap Growth?
I like these little research jaunts because I start out with one question, then learn something along the way that changes and improves the question. I began thinking that these four were candidates for the “large-cap growth” equities sleeve in a portfolio; I now see that VOO and DFUS are better described as US Core equity portfolios, even though they are predominantly large-cap growth (certainly DFUS less so). They don't quite work that well alongside small-cap value.
So, really, the question I should have asked is: What large-cap growth fund should I use when I also have a significant allocation to small-cap value? In a previous post, I wrote that AVUV was my new choice for small-cap value, so what complements it best?
(cue the elementary school teacher trick)…it’s a tie!
Both VUG and IVW look great, and performance between them is pretty much identical. Extending the argument, I’d feel fine with VOOG instead of VUG, and ok with RPG instead of IVW (RPG has a higher fee than IVW), though you might want to run those through their paces to make sure. If pressed, I might go with VUG because upside market capture sticks out a bit to me, its fee is ever so slightly lower, and it is a tad more “growth-y”, but honestly, this is a coin flip.
This doesn’t mean that VOO and DFUS are funds to avoid. I just think they found themselves in the wrong test. They might fare better if you removed the need to be complementary to small-cap value funds. If you just used one US equity fund, they might be fine. On the other hand, that might open the search up to other all-cap US equity funds that had higher allocations to the size and value premia, pushing these down in comparison. I suspect that Avantis might have a better product than either VOO or DFUS, if for some reason you just wanted a singular, all-in-one US equity fund.
By the way, I use VUG in the RPC Stability portfolio, where I pair it with VIOV. Based on the findings from this inquiry, I may change up the assets used in the test portfolios. Just for the record, in real life, I use VOO as a mainstay of my equity allocation, in addition to very similar funds like SWPPX. I also own a few shares in VIGAX, the mutual fund counterpart of VUG (though none in VUG itself).