When investing in mutual funds, you may wonder which kind is best: growth, value, or index. The main differences between the three include risk tolerances, strategies, and investing goals, but the most important difference is which ones perform better in a bear market and which ones do better when the economy is uncertain.
What's the Difference Between Value, Growth, and Index Funds?
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Performance: Value vs. Growth vs. Index Fund
Value stocks are considered to be undervalued and are purchased with the idea that they will perform better than expected. Growth stocks represent companies that have shown solid earning and growth purchased with the idea that they will grow at a rate faster than the overall stock market. Index stock funds seek to mimic the price movement of a certain index, which is a sampling of stocks or bonds that represent a segment of the overall financial markets. The Standard & Poor’s 500 (S&P 500) is an index made up of 500 of the largest U.S. companies by market capitalization. These include Facebook, Microsoft, and Amazon.
Few analysts would argue that value funds often perform better over time than growth funds in uncertain market conditions and economic environments. But growth stocks tend to perform better when markets are trending higher fueled by consumer confidence. Followers of both camps—value and growth objective investors—strive to achieve the best total returns.
Neither growth nor value investors can claim an outright victory in past performance history. Index investors can claim they may not often be the top performer, but they're less often the worst performer during a period. They can therefore be confident in receiving at least average returns for a lower average or below-average level of market risk due to diversification and low costs.
These are points based on the historical performance of value funds, growth funds, and index funds. No good investment advisor will advise market timing, but the best time to invest in growth stocks is often when times are good during the later, mature stages of an economic cycle, during the last several months that often lead up to a recession—but only if you intend to sell before the downturn.
Stocks issued by banks and insurance companies represent a larger portion of the average value mutual fund than the average growth mutual fund.
Volatility: Value vs. Growth vs. Index Funds
The total return of value stocks includes both the capital gain in stock price and the dividends, whereas growth stock investors often rely solely on the capital gain (price appreciation) because growth stocks don't often produce dividends.
Value investors enjoy a certain degree of "dependable" appreciation because dividends are fairly reliable, whereas growth investors often endure more volatility (more pronounced ups and downs) of price. Value stocks may do well when an economic recovery is in place, but may cool off if the stock market continues to perform well.
Index stock funds are often grouped into the "large blend" category of mutual funds because they consist of a blend of both value and growth stocks. An index investor often prefers a passive approach. They don't believe that the research and analysis required for active investing (neither value nor growth independently) will produce better returns that are always higher than that of the simple, low-cost index fund.
If you're not purchasing for the short term, you may want to buy your funds long before indications of a recession (or at the bottom of it). Ride it out. Hope for rewards on the reversal.
Return: Value vs. Growth vs. Index Funds
The manager of a value fund establishes the criteria and selects stocks that measure up. Such stocks will be selling at a price that is comparatively low in relation to one of the established criteria. By these criteria, the measures may imply a theoretical price higher than the currently traded share price. Earnings data or other fundamental value measures of the stock, such as debt-to-equity or the price/earnings-to-growth (PEG) ratio, are commonly used in value criteria.
Index investors may also believe that the blend of both value and growth attributes can combine for a greater result—the formula might be one-half value plus one-half growth equals greater diversity and reasonable returns for less effort.
Growth tends to lose to both value and index when a bear market is in full swing. The market is trending down. Prices are falling. Index funds don't often rule one-year performance, but they tend to edge growth and value funds over long periods, such as 10-year time frames and longer.
When index funds win, they often do so by a narrow margin for large-capitalization stocks but by a wide margin in mid-cap and small-cap areas. This is at least somewhat due to the fact that expense ratios are higher (and thus returns are lower) for the actively managed funds that are represented by growth and value.
This index outperformance for mid-cap and small-cap segments is also significant because many believe the opposite—that actively managed funds (not index funds) are best for mid-cap and small-cap stocks, but passive investing (indexing) is best for large-cap stocks.
The Bottom Line
Growth funds are comprised of stock from companies that have done well and are expected to keep meeting and exceeding earnings goals. You won't be able to buy them for a bargain, but you can expect solid returns with some volatility. When there's a bear market, don't be surprised to see growth performance go down.
Value funds are comprised of stock from companies that are expected to see bit strides in the future, but are relatively low cost when compared to growth stocks. They tend to perform well in uncertain economic conditions, but during recessions, they tend to not do as well.
Since index funds mimic benchmark funds, the returns will depend on whether they are comprised of value stocks, growth stocks, or both. Index funds tend to do better than value and growth stocks in the longer term.