Understanding what these terms mean and the differences between them is important and can make a big difference in the short and long term.
No single, agreed definition
Surprisingly for such oft-used terms, there is no technical, generally-agreed definition of growth funds and value funds. There is however general discussion on the characteristics of these funds and how they differ.
What is a growth fund?
Growth funds are typically a portfolio of shares of companies that are expected to have higher than average growth in profits – but that are not expected to deliver these returns particularly quickly. For this reason growth funds might appeal to those looking to invest for the long term. Companies in the portfolio may vary in size and could typically pay lower than average dividends if management decides to retain profits to try to grow the company in years to come.
Typically, growth funds are preferred by those who are optimistic about the growth and future earnings potential of the investment as well as those who do not need regular income from dividend payments.
What is a value fund?
Value funds usually consist of a portfolio of shares in companies that fund managers think are “under-valued” – or cheaper than the market average – and that tend to pay higher dividends than others.
These may be shares in companies that have suffered bad news and can be seen as a good deal and “good value” if the share price recovers. They may also appeal to those who need regular income from dividend payments.
Let’s get technical
Technical measures help indicate the types of characteristics of companies selected for growth funds and for value funds. Examples of these technical measures are the price-to-earnings multiple (P/E) and the price to book ratio (P/B). The P/E is calculated by dividing the share price by the earnings-per-share for the year. The price to book ratio compares the share price with the net value (assets minus liabilities) of the company. Both measures can be used to compare the share price of one company with another and can give a hint of how optimistic investors are about the prospects of different companies.
Growth funds – those made of companies expected to eventually have higher than average growth in profits – would likely consist of shares with higher PE and PB measures, suggesting faith in sustained earnings over time.
On the other hand, value funds would be expected to consist of shares in companies with PE or PB ratios below the average of a commonly used market average, such as the S&P or DAX index, as this can signal the market undervalues the shares.
Growth or value - which to choose?
There is no guarantee that either fund type will give higher returns over any period of time. There is some evidence, however, that the performance of growth and value funds move in cycles with one style outperforming for several years before the other takes the lead. In the years following the dot com crash, value funds gave higher returns, according to The Economist magazine. However, in many years before the dot com crisis, growth funds gave better returns.
Although it’s good to know the difference between a growth fund and a value fund, they are not the only options for active investors.
Billionaire investor Warren Buffett made that clear in his letter to shareholders in 2000 when he famously wrote: “market commentators and investment managers who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication”. Instead Buffett focuses on “intrinsic value”, which aims to value the company on fundamentals rather than share market value. Although also very subjective, it demonstrates the variety of choices for investors.