VUG: Backing A Growth Factor Tilt

The Vanguard Growth Index Fund ETF Shares (NYSEARCA:VUG) is in focus today as we turn our attention to factor investing. Although delivering robust returns since the start of the year, VUG ETF has pulled back by more than 2% in the past month, suggesting a pivotal point might’ve emerged.

Given its recent price action, I thought it would be an ideal time to assess the VUG ETF. Moreover, talks about an interest rate pivot and a spike in the S&P VIX Index provide latitude for systematic analysis.

Without further ado, here’s what I think of VUG ETF’s prospects.

An Overview of VUG ETF

VUG ETF is a tracker fund that aims to replicate the performance of the CRSP US Large Cap Growth Index. In essence, it provides investors with exposure to large-cap U.S. growth stocks. The ETF also aims to reduce concentration risk by limiting its position size to 5% per issuer and 10% of the issuer’s market capitalization.

Even though VUG ETF pays dividends, most of its returns have derived from price returns. The ETF’s beta coefficient of 1 means it has delivered its returns with relative consistency, as it has negligible idiosyncratic exposure. Nevertheless, as shown below, its return distribution is kinked, signaling that it possesses occasional tail risk.

Factor Analysis

In simple terms, an investment factor refers to a diversified portfolio with systematic risk attribution such as style, theme, fundamental aspects, and more.

VUG ETF provides systematic exposure to large-cap growth stocks, enabling investors to isolate their risk-return attribution. However, pure factor exposure usually leads to cyclical returns, so market timing is essential.

A regression analysis by MSCI shows that growth stocks exhibit outperformance whenever the U.S. yield curve enters, what’s called bullish steepening. Bullish steepening means that the short end of the curve is dropping faster than the longer end of the curve. However, I’d argue that an isolated drop in the short end provides enough evidence to suggest bullish steepening.

The Federal Reserve has kept rates unchanged. However, as recently shown, inflation has cooled, unemployment is rising, and consumer sentiment is deteriorating. As such, it is unsurprising to see the short end of the yield curve shifting down. In fact, the 40 basis point month-over-month downward shift in the one-year is my base case for bullish steepening.

A look at the longer end shows that rates have ticked up by about 37 basis points at the 30-year within the past month. Although an ideal bullish steepener would see the longer end drop, I think the move away from inversion and drops at the shorter end substantiates a bull steepener. Moreover, a twist has emerged in the intermediate basis of the curve, adding substance to a move away from flattening.

Aside: For those unaware, the yield curve illustrates what the market believes is the future distribution of short-term interest rates.

VUG ETF’s Portfolio Characteristics

As mentioned, I’m concerned by various economic factors. Such factors can stun nominal earnings growth and elevate stock risk premiums, leading to lower asset valuations. However, barring a crisis, I believe VUG ETF will surge through economic difficulty.

What’s my basis?

Although VUG ETF is a growth ETF, it has quality factor attributes, like a phenomenal return on equity ratio of 41.8%. Moreover, the ETF plays host to some of the most compelling modern technology companies, like Microsoft (MSFT), Apple (AAPL), NVIDIA (NVDA), Meta Platforms (META), and Tesla (TSLA). Therefore, suggesting the ETF is a secular growth vehicle instead of a cyclical growth ETF. Besides, let’s not overlook its earnings growth rate of 22.3%, which is an outlier compared to the forecasted U.S. GDP growth rate.

The following diagram illustrates VUG ETF’s tech-heavy exposure, with over 50% of its portfolio spanning large-cap tech. In addition, the ETF has prominent positions in communications and consumer goods. The ETF’s theme and sector growth rates dictate that the ETF’s composition will likely stay the same.

Peer-Based Commentary

Most of this article discussed factor-based price discovery. However, I wanted to focus on a few peer-based factors to add additional color. I collected data from Schwab U.S. Large-Cap Growth ETF (SCHG), Invesco Large Cap Growth ETF (PWB), First Trust Large Cap Growth AlphaDEX Fund ETF (FTC), iShares Morningstar Growth ETF (ILCG), and iShares Russell Top 200 Growth ETF (IWY). I recognize that the ETFs have slight differences. Nevertheless, they have similar style exposure, allowing for a comparative analysis.

Most growth vehicles have declined in the past month, so I don’t think a short-term pairs trade is in play. However, a longer-term vantage point shows that VUG ETF’s five-year performance is among the best, while its ten-year performance is in mid-quantile territory.

Further, the fund has a best-in-class expense ratio of 0.04%, which I find compelling as expense ratios can result in significant return decay when compounded. However, I am concerned by the fact that VUG ETF’s portfolio is more concentrated than those of its peers.

Risks To The Analysis

The analysis assumes that the parameters driving previous returns will remain constant, which isn’t always the case. Thus, I concede that there is a margin of error.

Furthermore, although systematic analysis can assign a probability to directional change, it isn’t useful to those seeking exact price discovery. As such, you could be entering at the wrong price, especially as VUG ETF has already surged by about 15% year-to-date.

Lastly, as mentioned before, the ETF’s returns are kinked, which is confirmed by looking at its Value-at-Risk metric. The metric shows that the VUG ETF has tail risk relative to the SPDR S&P 500 ETF Trust (SPY), meaning its return distribution might, at times, be non-normal, voiding the feasibility of systematic analysis in distressed market environments.

Wrap-Up

Given the yield curve environment and past regression analysis, I believe it might be an excellent time to pivot into a pure growth factor like Vanguard Growth Index Fund ETF Shares. Moreover, idiosyncratically, VUG ETF has high-quality features such as a stellar return-on-equity ratio, earnings growth, and household constituents.

Concerns regarding portfolio concentration and tail risk shouldn’t be disregarded. Nevertheless, I am net bullish about VUG ETF’s prospects.