Combining Growth and Value Boosts Large-Cap Returns

Morningstar’s vice president of research John Rekenthaler looked at whether it would be possible to outperform the S&P 500 index by splitting a portfolio into growth and value stocks. He specifically looked at holding both the Vanguard Growth Index fund (VIGRX) and the Vanguard Value Index fund (VIVAX).

He found that it was possible to outperform the S&P 500 by both holding and rebalancing the growth and value funds. The big advantage occurred when rebalancing was done once every five years. Doing so resulted in an annualized advantage of 0.28%. A portfolio holding the two funds rebalanced once every five years turned $10,000 into $87,013 on an inflation-adjusted basis. The same amount invested in the S&P 500 grew to $80,772 on an inflation-adjusted basis.

Rekenthaler analyzed return data for the period of December 1992 through May 2022. After seeing his findings, I was curious as to whether the advantage of combining growth and value held up over longer periods.

The Vanguard funds used by Rekenthaler both started in 1992, so doing an apples-to-apples comparison over a longer period was not possible. The workaround I opted for was to use Dartmouth professor Kenneth French’s online database. He has longer-term data on growth and value stocks. Growth in this case is defined as stocks with a high valuation, while value is defined as stocks with low valuations.

French also has return data based on market-capitalization size. Large is defined as a market cap ranking in the top 30%. This is a larger universe than the S&P 500 but close enough for our purposes. A market-cap-weighted portfolio of large-company stocks realized an annualized return of 11.2% between 1952 and 2021.

Historically, stocks with low valuations have outperformed stocks with high valuations by a wide margin. This is very evident in the French data. Between 1952 and 2021, portfolios of large-company stocks with low price-earnings (P/E) ratios (value) realized an annualized return of 14.4%. Portfolios comprising stocks with high price-earnings ratios (growth) realized a return of 10.3% over the same period. Value has also beaten growth by a wide margin when the price-to-book-value (P/B) ratio or the price-to-cash-flow (P/CF) ratio was used.

These returns simply pitted value versus growth. To see what would have happened if both were combined into a single portfolio, I tested a 50%/50% mix of value and growth rebalanced annually and rebalanced once every five years.

In both cases, overall returns for these split portfolios were better than merely holding large-company stocks in general. Using the price-earnings ratio to determine large-company growth and value stocks, the 70-year annualized returns were 12.6% and 12.7% for the 50/50 portfolios that were rebalanced annually and once every five years, respectively.

The returns for combining value and growth into a single portfolio were less appealing, however, than merely allocating to value alone. As the numbers above show, a portfolio solely allocated to large-company value stocks realized a nearly two-percentage-point return advantage over a 50/50 portfolio.

Growth dragged down the performance of the blended portfolios—even when no rebalancing was used. A similar effect occurred when price-to-book and price-to-cash-flow ratios were used. In all cases, the blended portfolios still outperformed the large-company-only portfolio. So there remained an advantage to splitting between growth and value. The advantage simply wasn’t as great as it would have been by solely allocating to value.

Rekenthaler’s analysis didn’t show an advantage to favoring value. This was due to the period he analyzed. The last 30 years were significantly impacted by the dot-com bubble of the late 1990s, last decade’s value drought and the historically low-interest-rate environment. During this period, growth outperformed value both on a price-to-book and price-to-cash-flow basis. On a price-earnings basis, value outperformed. The Vanguard growth fund beat out the Vanguard value fund.

The long-term odds favor value. The shorter-term (30-year) odds favor of growth. I personally prefer going with the longer-term odds as they cover a greater range of market and economic cycles.

Either way, both Rekenthaler’s and my analyses show a historical advantage to having replaced a broad market-cap-weighted large-company index fund with large-company growth and value funds [either mutual funds or exchange-traded funds (ETFs)]. If you choose to go down this path, look at the holdings of the mutual funds or ETFs you want to invest in. Depending on how they classify growth and value, the possibility of overlap exists. Pure value and pure growth strategies reduce the odds of this occurring.