What is a Growth Fund?

A growth fund is a type of actively managed mutual fund or exchange-traded fund (ETF) that invests primarily in companies with above-average growth potential. Growth funds aim to provide capital appreciation over long investment horizons by focusing on fast-expanding firms concentrated in sectors like technology, healthcare, consumer discretionary, and communication services.

Growth funds are actively managed portfolios attempting to beat overall market returns by identifying and investing in shares of firms exhibiting high earnings, revenue or valuation growth compared to industry peers and the broader market. However, growth funds tend to carry higher risks and fees than passive index funds.

What is a Growth Fund?

A growth fund is a diversified portfolio of stocks across various sectors and industries that is actively managed by an investment manager or management team. Growth funds focus on selecting and investing in companies experiencing high growth in financial metrics like revenue, earnings, and cash flows compared to overall market averages.

Growth funds aim to provide long-term capital appreciation by taking concentrated positions in stocks with strong growth trajectories. The fund managers actively research companies across sectors to identify promising growth stocks and rotate the fund’s holdings toward companies with accelerating growth.

Since higher growth potential is tied to higher expected returns, growth funds attempt to outperform broad stock market indexes over time by zeroing in on the subset of the equity market demonstrating standout growth. However, realized returns are highly dependent on the skill of the management team in selecting the top growth firms.

As actively managed strategies, growth funds typically have higher expense ratios than passive index funds but offer the potential to outperform the market through active stock picking and trading. Investors pay for professional management with the aim of being rewarded through excess returns over the long run.

How Do Growth Funds Work?

Growth funds are actively managed mutual funds or ETFs that take concentrated positions in stocks forecast to have above-average growth in financial metrics like earnings, revenue, profit margins, and cash flows. Here is an overview of how growth funds work:

• Research-driven stock selection – Growth fund managers thoroughly research companies across sectors to identify promising opportunities. This involves evaluating growth drivers, new products, competitive positioning, management quality, and valuation.
• Concentrated positions – Funds hold relatively concentrated positions in their highest conviction stock picks rather than diversifying broadly. Top 10 holdings often represent over 50% of assets.
• Flexible sector exposure – While focused on high-growth areas like technology and consumer discretionary, funds also seek opportunities across defensive and cyclical sectors.
• Emphasis on future growth – Current high growth is important, but funds also consider future trajectory based on product cycles, industry trends and competitive dynamics.
• Acceptance of higher valuations – Growth stocks often have higher price-to-earnings (P/E) ratios, which funds are willing to pay for higher expected growth.
• Long-term holding periods – While trading in and out of positions, funds still aim to ride long-term winners for years. Holdings are not flipped overnight.
• Actively traded – Managers are not passive indexers. They actively trade holdings trying to capitalize on changing growth trajectories in the market.
• Higher expenses – Actively managed funds have expense ratios around 1% or more, higher than comparable index funds.

Growth funds offer investors exposure to concentrated portfolios of stocks forecast to deliver above-average growth in business fundamentals over the long run.

Types of Growth Funds

While all growth funds target above-average growth stocks, some subclasses employ different approaches:

• Aggressive Growth – Focus on higher-risk small and mid-cap stocks growing extremely rapidly, accepting higher volatility.
• Growth and Income – Blend of growth stocks with companies also paying dividends to offer current income.
• Large Cap Growth – Concentrate on larger market cap stocks with steady above-average growth.
• Mid-Cap Growth – Target mid-sized companies in the growth sweet spot with room to expand.
• Small Cap Growth – Small caps grow rapidly in the early part of their life cycle but with volatility.
• International Growth – Invest in high-growth companies based outside the United States.

These subclasses allow investors some flexibility to fine-tune their desired growth strategy. Many core growth funds take a blended multi-cap approach across sectors.

Key Characteristics of Growth Funds

Growth funds share certain common characteristics that investors evaluating them should understand:

• Above-average growth – Funds target companies with revenue, earnings, or cash flows growing much faster than comparable firms and market averages. Growth over 20% annually is common.
• High valuations – Growth stocks often have higher price-to-earnings (P/E) and price-to-book (P/B) ratios, which funds are willing to pay for higher expected returns.
• Future growth orientation – In addition to current growth, holdings are selected based on positive future trajectory forecasts.
• Small and mid-cap exposure – Many explosive growth firms are smaller in scale, although funds also mix in larger caps.
• Sector concentration – Significant exposure to certain high-growth sectors like technology and healthcare.
• Active trading – Managers are constantly researching ideas and adjusting holdings pursuing changing growth opportunities in the market.
• Higher expenses – Actively managed funds have expense ratios around 1% or higher, costlier than passive index funds.
• Tax inefficiency – Active trading can realize more capital gains distributions causing tax drag for investors.

These attributes help give investors a feel for what to expect from growth fund performance, risk, and costs.

Pros of Growth Fund Investing

Growth funds offer some potential benefits for investors:

• Capital appreciation – The primary appeal of growth funds is long-term capital appreciation exceeding broader markets.
• Target high upside – Growth stocks have greater upside potential owing to their trajectory which funds aim to capture.
• Active management – Managers actively analyze companies and markets aiming to outperform passive indexes through stock selection and trading.
• Concentrated approach – Funds take concentrated positions in their highest conviction ideas unlike broad index funds.
• Flexibility – Actively managed approach allows rotating into different growth sectors and stocks as potential shifts.
• Core holding potential – As an all-equity fund, growth funds can serve as a core portfolio holding rather than a supplement.

For investors focused on maximizing capital appreciation over long time periods, growth funds offer an appealing solution.

Cons of Growth Fund Investing

Growth funds also have some potential disadvantages:

• Higher volatility – Concentrated investing in higher-growth stocks results in wider performance swings and larger losses during market declines.
• No dividends – Fast-growing companies plow profits back into the business instead of issuing dividends.
• Overvalued holdings – Funds may overpay for overhyped growth stocks whose financials disappoint.
• Underperformance – An actively managed approach does not guarantee outperformance versus benchmarks, despite higher fees.
• Tax inefficiency – Compared to indexes, active trading can result in larger taxable capital gain distributions.
• Manager risk – Excess returns rely heavily on the skill and discipline of the fund manager.

Growth funds carry above-average risks and costs. Investors must determine whether their investment profile aligns with the strategy.

READ ALSO: Mutual Funds vs. Stocks: Which is the Better Investment?

Examples of Top Growth Funds

Some well-known growth funds with competitive long-term track records include:

• Vanguard U.S. Growth Fund (VWUSX)
• Fidelity Growth Company Fund (FDGRX)
• T. Rowe Price Growth Stock Fund (PRGFX)
• ClearBridge Large Cap Growth Fund (SBLGX)
• JP Morgan Large Cap Growth Fund (SEEGX)
• Invesco QQQ ETF (QQQ) – Growth-oriented Nasdaq 100 large cap exposure
• iShares Russell 1000 Growth ETF (IWF) – Passive large cap growth index ETF

These actively managed mutual funds and ETFs represent some of the top growth strategies available to investors from leading asset management firms.

Evaluating Growth Funds

When researching growth funds, key factors to evaluate include:

• Past returns – Longer-term returns meaningfully above broad market indexes are preferable, although past performance alone does not guarantee future success.
• Volatility – Assess risk measures like standard deviation and beta to gauge the volatility profile relative to category peers. Higher is expected but very elevated volatility may signal excess risk.
• Fund manager – Examine manager tenure, track record, experience, and sell discipline. Long histories managing growth strategies through various market cycles are ideal.
• Market cap exposure – Ensure the fund’s average market capitalization and stated size objectives match your preferences. Many focus on small and mid-caps but some target large caps.
• Sector allocation – Look for style consistency with major allocations to high growth sectors like technology, healthcare, consumer discretionary, and communications.
• Valuation metrics – Compare the portfolio’s average P/E and P/B ratios relative to benchmarks to assess whether holdings are overly expensive.
• Trading frequency – Monitor the portfolio turnover as a gauge of how actively traded the fund is. Higher turnover may signal tax inefficiency.
• Total assets – Prefer funds with over $500 million in assets reflecting a proven strategy. Be wary of unproven funds without a long track record.
• Fees – Expense ratios around 1% are typical. Compare to category averages and similar index funds.

Doing thorough due diligence is critical before investing in any growth fund.

Role in a Portfolio

Growth funds can play several strategic roles within an investment portfolio:

• Core holding – The equity exposure makes growth funds a viable core portfolio holding for investors wanting an active stock picking strategy.
• Complement index funds – Blending active growth funds with low-cost index funds allows overweighting high growth stocks.
• Tactical growth exposure – Devoting a specific allocation to growth provides tactical exposure to higher expected return stocks.
• Focused sector exposure – Growth funds concentrated in certain sectors like technology offer segment bets.
• Satellite holding – More concentrated growth funds may fill a satellite role for fine-tuning a portfolio’s risk profile.
• Strategic large cap tilt – Large cap focused growth funds strategically tilt the portfolio to larger size exposure.

Growth funds fit within most diversified portfolios for investors seeking to add exposure to stocks with above-average growth potential.

Tax Implications of Growth Funds

The active trading nature of growth funds often makes them less tax-efficient than passive index funds. Key tax considerations include:

• Short-term gains – Frequent trading realizes more short-term capital gains taxed at higher ordinary income rates when distributed.
• Capital gain distributions – Active realization of winners generates larger capital gain distributions versus a buy-and-hold index fund.
• Tax drag – Higher taxes diminish net returns and can impair long-term compounding versus more tax-efficient strategies.
• Wash sales – Active funds may trigger wash sales when losses are harvested and replaced by similar stocks within a short window, disallowing the loss.
• Tax-favored accounts – Growth funds are generally best suited for tax-advantaged retirement accounts where taxes are deferred until withdrawal. Taxable accounts will incur higher annual taxes.

While expected with active funds, higher taxes are a cost of growth investing that should be incorporated into net return expectations.

Growth Funds vs Index Funds

Growth funds differ from index funds across a number of dimensions:

Growth Funds

• Actively managed by a fund manager
• Concentrated stock picking
• Attempt to outperform the market
• Inherently have more volatility
• Less tax efficient with higher turnover
• Higher expense ratios

Index Funds

• Passively track market indexes
• Broad diversification
• Closely match market returns
• Lower volatility profile
• Minimal trading means higher tax efficiency
• Very low expense ratios

Growth funds offer the potential for outpacing the markets through active management while assuming higher costs, volatility, and tax drag. Index funds provide reliable broad market exposure at minimal costs. Investors must weigh the merits of each strategy for their needs.

READ ALSO: Top Brokers for Fractional Share Investing in October 2023

Best Practices for Investing in Growth Funds

Here are some tips for investors in growth funds:

• Maintain a long-term horizon of at least 5-10 years given the potential for volatility.
• Diversify across multiple growth funds and combine with index funds to balance risk.
• Use tax-advantaged accounts to defer taxes on capital gain distributions.
• Reinvest dividends and distributions to compound returns.
• Ensure risk tolerance aligns with the accepted higher volatility of growth stocks.
• Assess funds based on after-fee performance adjusting for risk taken.
• Favor fund managers with long tenure managing growth strategies.
• Limit position size for any individual fund in line with overall portfolio risk limits.
• Periodically review sector allocations and market cap exposures for style consistency.
• Monitor tax efficiency by checking capital gain distributions and portfolio turnover.

Growth funds carry higher expected risk and costs but also higher potential returns for investors who incorporate them prudently into their equity allocation.

To Recap

Growth funds offer a way for investors to gain focused exposure to stocks exhibiting strong earnings, revenue, valuation, and market share growth compared to the overall market. Fund managers actively pick stocks forecast to deliver above-average growth and rotate holdings trying to capitalize on emerging opportunities earlier than the broad market. While growth funds carry higher fees and volatility, their potential for generating long-term capital appreciation makes them a popular fund category for many investors. However, prudent due diligence and risk management is vital to incorporate growth funds effectively into an investment plan.

Frequently Asked Questions

What is the difference between a growth fund and an aggressive growth fund?

Aggressive growth funds concentrate on higher risk small and mid-cap stocks with extremely high growth often exceeding 25-30% annually. They embrace very high volatility in pursuit of maximum growth potential. Core growth funds have a broader mandate that includes larger caps and sectors with more moderate but still above-average growth.

What is a good benchmark for evaluating growth funds?

The Russell 1000 Growth Index is a common benchmark for large cap growth funds. The Russell 2000 Growth Index evaluates small cap growth strategies. Broad equity indexes like the S&P 500 also provide general market comparisons. Using multiple benchmarks helps assess performance.

Are growth funds considered a high-risk investment?

Yes, growth funds carry high risk relative to core equity index funds due to their concentrated positions in higher volatility stocks with high valuations. Their wider performance swings and potential for significant loss during market declines makes them a higher risk strategy that investors should ensure aligns with their risk tolerance.

How much of a portfolio should growth funds comprise?

Growth funds are generally recommended as a supplementary portfolio allocation rather than the core holding. A 10-20% allocation to growth provides potential added returns while limiting risk versus putting 50% or more in growth. Individual allocations depend on an investor’s specific goals and risk tolerance.

Do growth funds pay dividends?

Most pure growth funds pay little or no dividends because high growth companies plow profits back into expanding the business. Investors should not expect material dividend income from most pure growth strategies. However, some blended “growth and income” funds do offer modest dividend yields.

Are growth funds appropriate for retirees?

Growth funds are generally unsuitable as a major holding for retirees given their higher volatility. Preservation of capital and income consistency are higher priorities in retirement. However, conservatively sized growth fund positions may be appropriate for some risk-tolerant retirees not fully reliant on portfolio cash flows.

In another related article, The Benefits of Long-Term Investments: Securing Your Financial Future