There’s no lack of diversity when it comes to equity mutual funds.
With several thousand funds available on the market today to choose from, investors’ options are virtually limitless. But despite the many different types of mutual funds out there, you might notice that there are two types that are most prevalent – growth funds and value funds.
While growth and value mutual funds might seem similar, understanding how they are different is what separates good investors from great ones. Each type of fund has strengths and weaknesses that can help your portfolio flourish and knowing which one to hold can be the key to bigger profits and fewer risks.
Find out about the most important criteria for selecting a mutual fund here.
Investing in Growth Funds
Growth-oriented equity mutual funds, as the name suggests, invest primarily in growth stocks. These stocks are expected to grow at a faster pace relative to the broader market and typically come with higher P/E ratios. While seemingly expensive, growth stocks ideally grow fast enough to justify the higher P/E ratio.
While growth stocks can be found in virtually all sectors, they tend to be more common in the technology industry. Small- and mid-cap stocks are also commonly labeled as growth stocks, although large-cap manufacturing stocks might also be defined as growth stocks as they take advantage of economies of scale to produce more of an item at a cheaper rate, thereby accelerating profits over time.
Investors that choose growth stocks usually have a higher risk appetite. Because growth stocks tend to have higher P/E ratios, they’re also more volatile investments and might rise or fall in value rapidly relative to the broader indexes.
Growth stocks usually pay little or no dividend – the company invests the profits back into the business to fuel growth. As a result, investors shouldn’t pick growth funds for income reasons. Rather than relying on dividends, investors expect growth stocks to outpace the broader averages and post higher returns.
Growth mutual funds tend to lean toward growth stocks in their portfolio. The T. Rowe Price Blue Chip Growth Fund (TRBCX) holds a number of large-cap growth stocks such as Amazon, Microsoft, Facebook, Boeing, Visa and more. However, growth funds don’t always hold large, well-known brands. For example, the T. Rowe Price Institutional Small Cap Stock Fund (TRSSX) holds companies such as John Bean Technologies, Teledyne Technologies, Cable One and other lesser-known stocks.
Investing in Value Funds
Value-oriented equity mutual funds hold value stocks in their portfolio. Unlike other stocks, value stocks are underrated or overlooked companies. They might have a lackluster chart performance as well. By definition, value stocks are companies that are undervalued and trade at a discount relative to their intrinsic value.
Value investing is one of the most popular forms of investing on Wall Street after famed investors like Benjamin Graham and Warren Buffett made it mainstream. It consists of finding undervalued companies that have the potential for outsized gains, but haven’t yet reached those levels. Unlike growth stocks, value stocks can take years to reach their potential so only investors with a long-term time horizon should consider investing in value stocks.
Conservative and aggressive investors alike might find value stocks to be an appropriate choice for their portfolio. Conservative investors might lean more toward cyclical value stocks – companies that are out of favor due to the economic cycle but are not necessarily poor companies. More aggressive value investors might pick speculative stocks – small-cap companies with little to no analysts’ coverage, which could mean the stock price isn’t trading at its real fair value.
Unlike growth stocks, dividends play a large role in value stock investing. This makes value stocks perfect for income investors and long-term growth when dividends are reinvested.
Value stock mutual funds hold a portfolio that mainly consists of value stocks. For instance, LSV Value Equity Fund (LSVEX) holds a number of large-cap value stocks like JP Morgan Chase, Intel, Johnson & Johnson, Pfizer and other value positions. Examples of holdings in a small-cap fund like DFA US Targeted Value I (DFFVX) include Kohl’s, Toll Brothers, Macy’s, Avnet and more.
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The Bottom Line
Both growth and value stock mutual funds have a place in an investment portfolio. A well-rounded portfolio should have at least one growth stock and one value stock in it to be truly diversified. While mutual funds tend to be labeled as either a growth fund or a value fund, holding one of each could be the best way to go.
Investors should also note that mutual funds come in all flavors – you could have a large-cap growth fund and add a small-cap value fund for extra diversification. While aggressive investors can’t go wrong with either type of stock mutual fund, conservative investors should lean more heavily on value stocks to minimize risks.
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