Mutual Funds: Growth or Value?

March 4, 2004 -- For investors trying to decide whether to putmore money in value funds or growth funds, the current marketoffers little guidance, although recent returns show value mighthave a slight edge.

Over the last year, growth funds had a modest advantage, as theyoften do in strong markets. Since the start of 2004, however, valuefunds have outpaced them, according to research firm Lipper Inc.The largest difference can be see in the large-cap area, wherevalue funds have seen a return of 3.5 percent since Jan. 1, whilegrowth gained only 2.36 percent.

With the market's near-term outlook uncertain, most financialprofessionals recommend investors continue to hold a mix of bothstyles.

If you're looking to make small adjustments around theedges of your portfolio, however, it usually makes sense to do itin a way that runs counter to what's going on in the marketplace,said Emily Hall, senior mutual fund analysts with Morningstar Inc.

"You don't necessarily want to run up your growth exposureafter growth has had a huge run, like now, because you might begetting in at higher price levels," Hall said. "You don't want tochase past performance."

Understanding the Terms

For a novice investor, the words "value" and "growth" mighthold equal appeal, but they can have vastly different meanings onWall Street. Which strategy is better is a matter of debate, andpersonal preference.

Value investors are bargain-shoppers. They seek out underpricedcompanies with strong fundamentals that have temporarily fallen outof favor. Value funds tend to be less volatile because they focusmore on safety than growth, often investing in more maturecompanies that pay dividends.

When professional investors talk about growth stocks, they'reusually looking for companies with great potential that will givereturns in the form of future earnings appreciation.

Growth managers are always on the lookout for the next big thing, andoften invest in young companies that are rapidly expanding, whichmakes their funds more volatile. To them, the steady, ploddingperformance of value stocks seems dull.

Yet academic research has shown consistently that valueinvesting produces better returns over time — up to 7 percent ayear on average, said Lubos Pastor, a finance professor at theUniversity of Chicago Graduate School of Business.

This "value premium" seems to support the theories of famous investors likeWarren Buffett and his mentor, Benjamin Graham, but academics arestill trying to understand why the strategy has such an edge.

There are two possible explanations why value outpaces growth,Pastor said. One is that investors become irrationally optimisticabout growth stocks, overreacting to good news only to realizetheir mistake later when returns diminish. The other possiblereason is less intuitive: Some researchers have suggested that theseemingly staid value stocks are actually a riskier investmentoverall.

Which Funds Carry More Risk?

The risks associated with growth investing are usuallyfirm-specific, and can be offset by holding a larger number ofcompanies, so the successes and failures average out, Pastor said.But recent research argues that value investing poses different andpotentially greater risks that can not be countered bydiversification. Some suggest this is because as a group, valuecompanies may be more susceptible to market downturns.

"This is one of the most interesting questions in empiricalresearch," Pastor said. "If you do not believe it's true thatvalue stocks are riskier than growth stocks, then you should buyvalue. If you believe it is true, and various studies suggest it'snot clear, you should be indifferent. It all depends on yourperception." Followers of either style can have an almost religiousintensity, but sometimes the lines between value and growth canblur. Because money managers conform to these strategies to varyingdegrees, you should never assume anything about a fund just becauseit has the word "value" or "growth" in its name.

Rather than subscribe to either style, Sheldon Jacobs, editorand publisher of The No-Load Fund Investor, prefers funds thatblend value and growth strategies.

"If you think about it, if you're in a fund with a certainstyle, you're guaranteed to be a laggard at some point," Jacobssaid. "Whereas if you bought a fund that is not style-specific intheory, the management could go wherever the leadership of themarket goes."

No matter what approach a fund takes, you should always lookclosely to see how its holdings fit in with the rest of yourportfolio, with an eye toward what kind of risks you're willing totake, and how much volatility you can stomach.

"The small investor should go with their gut. I ask my clients,can you sleep at night with this choice? What can go wrong? Well,things could go south. How far south? Well, if you're in growth, tozero," said Peter Calfee of Calfee Financial Advisors Inc. inCleveland, who also prefers a blended approach. "The everydayinvestor needs to have balance."