The Vanguard Mega Cap Growth Index Fund ETF Shares (NYSEARCA:MGK) is too risky for me to recommend. What are the specific risks I see? Let’s dig in.
MGK is an ETF that passively tracks the CRSP US Mega Cap Growth Index. The index represents the growth style for companies in the top 70% of cumulative capitalization of CRSP US Total Market. The median market cap of stocks in this portfolio is $1.8 trillion!
How does the index define growth? They measure it using the following factors:
- Future long-term growth in earnings per share
- Future short-term growth in EPS
- 3-year historical growth in EPS
- 3-year historical growth in sales per share
- Current investment to-assets ratio
- Return on assets
The trailing 10-year performance has been knocking it out of the park with nearly 16% annual returns.
So why am I reluctant to recommend buying this fund if it has been performing so well?
Position Risk
The fund currently has 79 positions as of May 31st, 2024. Normally, this wouldn’t raise big red flags except that these positions are non-diversified and are cap-weighted.
- If these 79 positions were equally weighted, each position would represent 1.26% of the portfolio.
- Due to the nature of cap-weighting, the largest 10 positions (as of May 31st, 2024) make up more than 65% of the portfolio.
- The biggest 3 stocks make up nearly 40% of the portfolio.
The individual stock concentration risk is extreme. This is not a well-diversified fund. If any of the top 3 stocks decline, it will have great influence on the entire portfolio.
Sector Risk
Now a portfolio that is effectively 3 – 10 stocks is risky. Any one of those companies can fall out of favor and the overall portfolio will drop. But also look at the sector risk. Weighted equity exposure is over 60% in the technology sector.
The past 10 years have been great for tech stocks, particularly the Mag7 and almost anything associated with AI. But investing in this fund exposes you to undue risk if and when the Tech/AI premium dies down. It is early days for AI so it is understandable why people are excited and making large predictions about its potential impact. I am excited too.
But this also reminds me a little of the dot-com bubble in the late 90s, where anything associated with the Internet had soaring valuations. And that was followed by a massive crash. I am not saying this is exactly the same. But if you look at stocks such as NVDA, it is clear that valuations are high and expanding far beyond fundamental growth.
The following chart compares 5 years of sales growth vs. price growth. Price is outstripping sales growth by a lot!
This means that high sustained future growth is already baked in. If the future disappoints even a little, prices could reverse. We have a potential bubble on our hands.
Risk of Cap-Weighted Premium
We also have the risk of the cap-weighted premium. Over the past 10 years, the cap-weighted version of the S&P 500 has outperformed the equal-weight version.
But cap-weighting has typically underperformed over time. An interesting 2013 paper called, An Evaluation of Alternative Equity Indices – Part 1: Heuristic and Optimised Weighting Schemes, found that between the years 1968 and 2011, every alternative weighting scheme (vs. cap-weighting) produced better risk-adjusted returns. Even 10 million random weighting schemes with zero thought put into them produced far superior returns to cap-weighting.
The past 10 years have been the exception. The question is, do you want to side with recent performance of cap-weighting that has been due to luck in a few concentrated positions? There is no logical reason why the largest companies should outperform simply because they are big. In fact, many academics feel the opposite, in that the largest market capitalization stocks could have a bias toward being overly expensive. You buy a bigger position in a company simply because it is more expensive and this could, in time, lead to losses when prices normalize to fundamentals.
To highlight the variability of a highly concentrated cap-weighting scheme, I created a portfolio of the 10 largest stocks in the S&P 500. They adjust over time to the historical holdings of the S&P 500. In addition, I cap-weight the positions to further make my point. The benchmark will be the equally weighted S&P 500 which trades as the RSP ETF.
The past decade has been favorable, but before that, it is a sea of red. And the research paper highlighted in an above paragraph shows that the sub-optimal nature of cap-weighting has persisted from 1968 – 2011.
Risk of High Valuations
Growth stocks typically have higher valuations because it is based on future growth expectations. This is to be expected and is the nature of growth stocks. But what happens when future growth disappoints? Underperformance.
Even if future growth is high, it must measure up to current expectations, which are already baked into the price. An average P/E ratio of 38 and a P/B ratio of 11.5 is indeed high. Is it too high? Time will tell but based on the hype surrounding AI technology, companies have a very high bar to jump over for sustained outperformance.
Conclusion
This fund simply has too many risks associated with it for me to recommend it.
- Weighting is centered in too few stocks.
- The weighting itself is due to market capitalization which has not held up long-term and is instead associated with under-performance with the past 10 years being the exception.
- The fund is highly concentrated in tech stocks.
- And because they are stocks with high valuations due to high expected growth, there is the risk that future growth will not meet current expectations, which will be met with under-performance.
The fund might luck out and do well if the top 10 stocks can continue to climb upwards. But I have seen this play out before. Things are good until they aren’t. And with so few positions concentrated so highly, any one of these (growth, individual stocks or tech sector) can sour and pull the entire portfolio with it. I simply cannot recommend this ETF due to its high risk.
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