When looking to add an equity-focused exchange-traded fund (ETF) to a portfolio, you usually have to choose between one of two broad categories: growth and value. Value ETFs look to invest primarily in the stocks of companies that are considered undervalued using metrics such as the price-to-earnings (P/E) ratio compared to either their peers or the broader market in general. Growth ETFs, in contrast, focus on investing in more volatile, faster-growing companies in the hopes of realizing above-average returns.
Both of these strategies can yield market-beating returns. Your individual risk tolerances, investing goals and current portfolio composition are the most important factors in determining whether to add a growth or value ETF to a portfolio.
Consider Personal Risk Preferences and Goals First
Generally speaking, having both value and growth ETFs in a portfolio provides valuable risk-reducing diversification benefits, but your individual risk tolerances determine the right mix.
If you have difficulty stomaching regular market fluctuations, stick with a more conservative value ETF. If you're comfortable with more volatility in an attempt to achieve above-average returns, you may prefer a higher allocation to growth ETFs.
Time horizon should also be a primary consideration. You can generally take more risk if your money stays invested longer. Longer time horizons allow you a better chance to ride out short-term market volatility. Younger investors adding to an individual retirement account (IRA), for example, have decades to remain invested and can take some additional risk to pursue higher returns.
When to Choose a Value ETF
A big factor in choosing between growth and value is the current portfolio. If you're starting out for the first time, build a portfolio around a core of highly rated value ETFs. These funds tend to consist of companies that produce products used every day by just about everybody. Examples of traditional value stocks include AT&T, Procter & Gamble, General Electric and Coca-Cola.
These companies look to provide conservative long-term growth with comparatively lower volatility. Another benefit of adding value ETFs to a portfolio is their dividend yields. These companies tend to be bigger cash flow generators, and that cash flow often gets paid out in the form of dividends. Dividends provide you with a predictable income stream that can become a significant percentage of a value ETF's overall shareholder return.
When to Choose a Growth ETF
Growth ETFs generally complement a core portfolio. Popular growth names such as Facebook, Amazon and Alphabet can deliver above-average returns, but they also come with a great deal of volatility and can struggle especially in times of economic weakness. A portfolio consisting primarily of growth ETFs can expose you to excessive risk, but when balanced with value ETFs, they can create an appealing risk/return profile.
If you're seeking a regular income from a growth ETF, you're likely to be disappointed. Many growth-oriented companies reinvest available cash back into growing the business instead of paying profits out to shareholders directly. Many of these companies pay little, if anything, in regular dividends.
What to Look for in Any ETF
Choosing between a value and growth ETF is only part of the decision-making process. Choosing the right ETF is just as important.
Examine what the fund typically invests in and how it is managed. A fund with a manager who has been at the helm for several years provides a track record of historical performance and a sense for how the fund is managed. Some funds, for example, are categorized as value funds, but they carry large allocations to riskier sectors such as technology. Make sure you know what you are buying.
Also consider a fund's expense ratio. Fund expenses cut directly into returns; avoid funds with above-average expense ratios.