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Michael Coote gets to the bottom of growth funds; finds out that growth is in the eye of the fund manager. Says investors need to drill down

Personal Finance
Michael Coote gets to the bottom of growth funds; finds out that growth is in the eye of the fund manager. Says investors need to drill down
<p> Going for growth</p>

By Michael Coote* (email)

Growth funds are back in vogue, at least according to fund managers who offer them, so get in quick they advise.

One of the curiosities about growth funds is how little agreement there seems to be about what they actually are.

Before investors take the plunge, they should be aware of just what sort of “growth” they are buying with any particular fund.

A survey of some standard definitions of growth funds throws up contradictory answers, as is evident in the links below.

In common across definitions is that growth funds invest in primarily if not exclusively in share markets, that capital gains are their sole return objective, that they are riskier and more volatile than funds that do not concentrate on capital gains, and that investors must be in for the medium-to-long-term (five to ten years) in order to profit substantially.

Beyond that, the definitions seem to go all over the place.

No consensus on growth

One major divide between definitions is whether it is the fund that grows in value simply because it invests across the general share market, or whether the fund must specialise by selectively investing in growth companies or, alternatively, in growth stocks.

The split could be summed up as lying between generalist growth funds and specialist growth funds.

If it is just the fund that is supposed to grow, then it could invest in pretty much anything in the share market so long as there was capital gain.

The American Heritage Dictionary conveys this sort of broad, generalist (and widely accepted) meaning where it says that the definition of a growth fund is that it “offers long-term capital appreciation.”

However, this is not what some people mean by growth, as they are talking about market-beating, above-average, or even extraordinary capital gains, and not just a fund that goes up more or less in line with the share market over extended time.

Here things get quite tricky as to what sort of growth is being referred to or how it is derived.

Technically speaking

The Investopedia Financial Dictionary defines growth funds as offering “higher potential capital appreciation but usually at above-average risk”, and this is because such funds specialise by investing in “companies with above-average growth in earnings that reinvest their earnings into expansion, acquisitions, and/or research and development.”

So here we are talking about a growth fund being defined on the basis of what it invests in on a specialised basis - growth companies – with such companies being defined in turn as established firms that plough their above-average earnings back into building up the business.

These growth companies represent a subsector of the share market, and so an Investopedia growth fund is not the same thing as an American Heritage growth fund that could invest across the whole share market.

But this is not good enough for Barron’s Finance and Investment Dictionary, which defines a growth fund as specialising in growth stocks.

Growth stocks, according to Barron’s, are “shares of young companies with little or no earnings history. They are valued on the basis of anticipated future earnings and thus have high price-earnings ratios. They generally grow faster than the economy as a whole and also faster than the industry of which they are a part. They are risky because capital gains are speculative, especially in the case of young companies in new industries. An example of a growth stock is a high-tech company.”

The young and aggressive

Barron’s growth stocks represent young, unprofitable, speculative ventures - very different beasts from Investopedia’s established, highly profitable, self-reinvesting companies.

The most likely business overlap shared between both types of firms would be investment in “expansion, acquisitions, and/or research and development”, but otherwise they are in quite different share market subsectors.

Accordingly a Barron’s growth fund is not the same thing as an Investopedia growth fund, even though they are both specialist growth funds as opposed to the generalist American Heritage growth fund.

To complicate matters further, Investopedia defines an aggressive growth fund as seeking the “highest capital gains” by specialising in “companies that demonstrate high growth potential, usually accompanied by a lot of share price volatility.”

High growth potential is ambiguous because it could mean Barron’s growth stocks as easily as Investopedia’s growth companies.

Yet, according to Investopedia, these specialised aggressive funds have high positive correlation (“large beta”) with the general share market, because they “tend to perform very well in economic upswings and very poorly in economic downturns”, which makes them more like American Heritage generalist growth funds in performance behaviour.

More art than science

Moreover, an Investopedia aggressive growth fund can invest in much else besides high growth potential companies, including quick turnaround trades in company initial public offerings (IPOs) and also “options to boost returns.”  

Clearly, defining growth funds is more an art than a science, and much depends on what fund managers mean when they claim that they offer such investments.

Going back to our starting point, growth fund managers are confident that their time has arrived again based on global economic outlook and improved company earnings prospects, but much depends on what exactly they define by growth and how precisely they will achieve it.

To recap, growth could mean capital gains arising from a fund investing:

1)      Generally across the sharemarket(s)

2)      Specifically in highly profitable established firms that reinvest in themselves

3)      Specifically in young, unprofitable, speculative ventures

4)      Specifically in companies with high growth potential (and possibly also IPOs and options)

5)      Something else altogether

Before investors leap onto the growth story bandwagon, they had better check out very carefully what particular sort of growth a fund on offer invests in and map that onto the prospects for the global economy, including allowing for expected differences in economic performance ahead between developed countries (lower) versus emerging markets (higher).

Investors should further compare the kind of growth exposure on offer with their own personal financial needs, objectives, circumstances and risk profiles to ensure there does indeed exist a genuine match up of all of them that is worth writing out a cheque for.

How does my growth fund grow?

What is a growth fund?

What is a growth stock?

What is an aggressive growth fund?


*Michael Coote is a freelance financial journalist whose publication list includes, the National Business Review, New Zealand Investor, The Press, and the New Zealand Centre for Political Research.

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