Value vs Growth vs Index Investing

When Is the Best Time to Invest in Index Funds vs Value and Growth?

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Which funds perform the best - value, growth or index funds?. Getty Images

The value vs growth debate is as old as investing itself. Which is best, value or growth? When is the best time to invest in value stock mutual funds? When is the best time to invest in growth stock mutual funds? Is there a smart way to balance both value and growth in one mutual fund? What happens to the debate when we enter index funds into the comparison?

Definitions of Value, Growth & Index Stock Funds

  • Value stock mutual funds primarily invest in value stocks, which are stocks that an investor believes are selling at a price that is low in relation to earnings or other fundamental value measures.
  • Growth stock mutual funds primarily invest in growth stocks, which are stocks of companies that are expected to grow at a rate faster in relation to the overall stock market.
  • Index stock funds seek to mimic the price movement of a particular index, which is a sampling of stocks or bonds that represent a particular segment of the overall financial markets. For example, the Standard & Poor’s 500 (S&P 500), is an index representing roughly 500 of the largest US companies (large-cap stocks), such as Wal-Mart, Microsoft and Exxon Mobil. This article will also analyze the S&P Midcap 400 (mid-cap stocks) and the Russell 2000 (small-cap stocks).

The Debate: Strategies and Comparisons for Value & Growth

There is no doubt that value stocks generally perform better than growth in certain market and economic environments and that growth performs better than value in others. However, there is no question that followers of both camps--value and growth objectives--strive to achieve the same result--the best total return for the investor.

Much like the divides between political ideologies, both sides want the same result but they just disagree with the way to accomplish that result (and they often argue their sides just as passionately as politicians)!

Value investors believe the best path to higher returns, among other things, is to find stocks selling at a discount; they want low P/E Ratios and high dividend yields.

Growth investors believe the best path to higher returns, among other things, is to find stocks with strong relative momentum; they want high earnings growth rates and little to no dividends.

Value vs Growth: Perspective on Returns

It is important to note that the total return of value stocks includes both the capital gain in stock price and the dividends, whereas growth stock investors must rely solely on the capital gain (price appreciation) because growth stocks do not often produce dividends. In different words, value investors enjoy a certain degree of "dependable" appreciation because dividends are fairly reliable, whereas growth investors typically endure more volatility (more pronounced ups and downs) of price.

Furthermore, an investor must note that, by nature, financial stocks, such as banks and insurance companies, represent a larger portion of the average value mutual fund than the average growth mutual fund. This oversize exposure can carry more market risk than growth stocks during recessions. For example, during The Great Depression, and more recently The Great Recession of 2007 and 2008, financial stocks experienced much larger losses in price than any other sector.

How Index Funds Compare to Value and Growth

Index stock funds are normally grouped into the "Large Blend" objective or category of mutual funds because they consist of a blend of both value and growth stocks.

An index investor usually prefers a passive investing approach, which is to say that they don't believe the research and analysis required for active investing (neither value, nor growth independently) will produce superior returns that are consistently higher than that of the simple, low-cost index fund. Index investors may also believe that the blend of both value and growth attributes can combine for a greater result -- a "one plus one equals three" effect (or actually one-half value plus one-half growth equals greater diversity and reasonable returns for less effort).

Key Takeaways From Historical Performance of Value, Growth and Index Funds

These are points worth noting from historical performance of value funds, growth funds and index funds.

  • Growth stocks tend to perform best in the last year of the business cycle, before recession begins.
  • Growth tends to lose to both value and index when a bear market is in full swing.
  • I don't recommend market timing but the best time to invest in growth stocks is typically when times are good during the latter (mature) stages of an economic cycle.
  • Index funds don't often dominate one-year performance but they tend to edge out growth and value over long periods, such as 10-year time frames.
  • When index wins, it typically wins by a narrow margin for large cap stocks but by a wide margin in mid-cap and small-cap areas. This is at least partially attributable to the fact that expense ratios are higher (and thus returns are lower) for the actively-managed funds represented by growth and value. This index out-performance for mid-cap and small-cap segments is also significant because many investors believe the opposite -- that actively-managed funds (not index) are best for mid-cap and small-cap stocks but passive investing (indexing) is best for large-cap stocks. For more in this point, see Efficient Market Hypothesis (EMH).
  • Neither growth nor value investors can claim an outright victory in past performance history. However, index investors can claim that they may not often be the top performer but they are less often the worst performer during the period. Therefore, they can be confident in receiving at least average returns for an average to below-average level of market risk due to diversification and low costs.

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.