IWY: Growth Gets Better With Size

| About: iShares Russell (IWY)
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By Alex Bryan

Mega-cap growth companies tend to enjoy strong profitability, sustainable competitive advantages, and of course, healthy growth. While growth stocks have historically lagged their value counterparts in nearly every market studied over long horizons, this performance gap is the smallest among mega-cap stocks. That may be because mega-cap growth stocks represent many of the market's most profitable companies. Recent studies have found that the stocks of highly profitable companies tend to outperform their less profitable counterparts with similar valuations.

With its narrow focus on mega-cap growth stocks, iShares Russell Top 200 Growth Index (NYSEARCA:IWY) offers a higher concentration of quality companies than most of its peers. It invests in the faster-growing and more expensive half of the Russell Top 200 Index, which tracks the 200 largest U.S. companies by market cap. Although these companies tend to grow more slowly than their smaller counterparts, they also tend to be more profitable and less volatile. There is some evidence that the market does not fully appreciate the long-term persistence of high-quality firms' earnings power. As a result, there may be an opportunity for long-term investors to profit from the market's myopic focus by buying the type of quality stocks this fund holds at reasonable prices.

Nearly every company the fund owns carries either a wide or narrow economic moat, Morningstar's assessment that a firm enjoys a sustainable competitive advantage. In fact, more than 62% of fund is invested in companies with wide economic moats, while the corresponding figure for the Russell 1000 Index is 38%. These competitive advantages have enabled the fund's holdings to generate higher returns on invested capital than the broad Russell 1000 Index, on average. Through April 2013, the fund's holdings generated an average trailing 12-month return on invested capital of 17.1%, while its value counterpart, iShares Russell Top 200 Value Index (NYSEARCA:IWX) posted only 10.1%. The corresponding figure for the Russell 1000 Index was 12.3%. Durable competitive advantages also help the fund's holdings weather tough economic climates a little better than the broad market.

Because the fund covers approximately half the mega-cap market, it includes some blend stocks that dilute its growth tilt. In fact, about one fourth of IWY's portfolio overlaps with its value counterpart, IWX. However, these holdings help damp the fund's volatility and limit its exposure to more expensive fare, which is not such a bad thing. High-quality names, such as McDonald's (NYSE:MCD), Microsoft (NASDAQ:MSFT), IBM (NYSE:IBM), Coca-Cola (NYSE:KO), and Altria (NYSE:MO), dominate the portfolio.

Fundamental View
Overpaying for growth can wipe out its benefits. However, as of this writing, the fund is trading at a price/fair value multiple of 1.01 based on Morningstar equity analysts' assessments of the fund's underlying holdings. That's close to IWX's 0.98 price/fair value multiple. Therefore, although IWY is trading at a richer price/earnings ratio relative to its value counterpart (18.3 and 14.7, respectively), its holdings don't look significantly more expensive relative to their future cash flows.

The emergence of social media and cloud and mobile computing is altering the landscape of technology industry, where more than a fourth of the fund's assets are invested. While that shift has hurt many established technology titans, such as Microsoft and Intel (NASDAQ:INTC), it has benefited several of the fund's other holdings, including Amazon.com (NASDAQ:AMZN), Apple (NASDAQ:AAPL), and Oracle (NYSE:ORCL). In our view, these long-term trends are a net positive for the industry and should continue to fuel its growth.

The fund's holdings should also continue to benefit from the strengthening U.S. economy. Households and companies have reduced their leverage in recent years, consumer spending is reasonably healthy, inflation is low, manufacturing activity and oil production have picked up, and the unemployment rate has continued its gradual decline. Renewed strength in the housing market could continue to drive the recovery forward and further bolster consumer spending. While the market has already priced in much of this improvement, U.S. companies may be more willing to invest in growth as confidence picks up. Many mega-cap stocks have amassed a lot of cash on their balance sheets, which could be used to finance growth or increase distributions to shareholders.

The picture is less bright across the Atlantic, where austerity measures, deleveraging, and uncertainty resulting from the sovereign debt crisis have depressed demand. This weakness continues to present a headwind for the fund's multinational holdings.

Portfolio Construction
The fund employs full replication to track the Russell Top 200 Growth Index. The portfolio construction process begins with the Russell Top 200 Index, which includes the 200 largest U.S. companies by market capitalization. Russell assigns a composite value score to each stock in the Russell Top 200 Index using one value factor (price/book ratio), and two growth factors (I/B/E/S medium-term growth forecast and five-year historical sales per share growth). The two growth factors receive the same weighting in this calculation as the single value variable. It then ranks stocks according to this composite value score and fully allocates those representing 35% of Russell Top 200 Index’s market cap with the lowest value scores to the growth index and the highest 35% to the value index. Russell partially allocates those stocks that fall in between these cutoffs to both the value and growth indexes, based on the relative strength of the stock's value and growth characteristics. Together, the value and growth indexes represent 100% of the assets of the Russell Top 200 Index. Russell reconstitutes the growth index annually.

IWY's 0.20% expense ratio is low, but there are cheaper alternatives. For instance, Vanguard Mega Cap Growth Index ETF (NYSEARCA:MGK) offers similar exposure for 0.12%. The liquidity of the fund's underlying holdings helps keep transaction costs and deviations from NAV low. The fund has lagged its benchmark by slightly more than the amount of its expense ratio over the past three years.

MGK offers very similar exposure at lower price (0.12% expense ratio). MGK extends its reach further down the market-cap ladder than IWY. However, it offers a similar quality tilt. In fact, more than 81% of the two funds' portfolios overlap. Over the past three years, IWY and MGK were nearly perfectly correlated. Investors who find MGK's portfolio of quality companies appealing should also consider iShares S&P 500 Growth Index (NYSEARCA:IVW) (0.18% expense ratio), which offers a similar concentration of wide-moat holdings. IVW offers a broader portfolio than IWY, which gives it a lower average market cap. Unlike most of its peers, IVW incorporates price momentum into its stock selection criteria.

Vanguard Growth ETF (NYSEARCA:VUG) (0.10% expense ratio) and Schwab U.S. Large-Cap Growth ETF (NYSEARCA:SCHG) (0.07% expense ratio) are the cheapest alternatives. The average market capitalization of their holdings is less than half of IWY's, which can make them slightly more volatile. However, over the past three years, these two funds were nearly perfectly correlated with IWY.

Guggenheim S&P 500 Pure Growth (NYSEARCA:RPG) (0.35% expense ratio) offers cleaner exposure to stocks with strong growth characteristics and fewer large-blend names. Unlike IWY, RPG imposes a buffer between value and growth stocks and excludes stocks that do not exhibit a dominant growth style. This pure style exposure has made RPG more volatile than IWY, over the past three years. However, because S&P rebalances the index only once a year, RPG can experience some style drift throughout the year.