Just Add Water? Investing in Growth Funds for Risk and Reward

A well-balanced investment portfolio is diversified across various asset classes, and many investment consultants recommend placing a considerable chunk of that capital into conservative instruments like bonds or dividend-paying stocks. However, if you’re comfortable taking on a bit more risk in exchange for the potential of more aggressive returns, a growth fund might be something to consider.

Highest and Best Use of Capital

A growth fund is a basket of stocks designed to deliver capital appreciation—an increase in the underlying stock price—as opposed to delivering cash flow via dividend payments. Growth funds generally come in three different categories: large-cap, mid-cap, and small-cap. They often include newly public companies and other stocks that may be more volatile than the market as a whole.

The managers of these funds look to hold companies that they believe will experience greater than average growth in metrics like earnings, revenue, or cash flow. In general, growth fund managers like companies that plow their excess cash into growth initiatives or acquisitions, as opposed to paying it out to shareholders in the form of dividends. The rationale here is that if a company is experiencing outsize growth, and that growth is expected to continue, the highest and best use of capital is within the company, and not distributed to shareholders as dividends.

And we’re not necessarily talking only about domestic funds. Over the past several years, there has been a notable increase in the number of foreign growth funds on offer. Like their domestic counterparts, these funds invest in stocks with strong earnings and revenue growth—mostly in the consumer and tech sectors—and are designed for investors who want to take advantage of a global growth strategy.

Moving with the Market

Growth funds can be highly correlated to market movements, and their volatility can cut both ways, underperforming when the market is down and outperforming when it rallies. That’s why they may be an asset best suited for a strong overall economic climate.

In 2016, the market stumbled out of the gate on worries of an economic slowdown in China, and many growth funds took a hit. But as the market found its footing and rallied into mid-year, growth funds began to outperform, and despite a slight setback after the U.K.’s June 2016 vote to leave the European Union, growth funds soon resumed their rally and then rocketed higher along with the broader market after the November 2016 U.S. elections.

As an asset class, growth funds ended 2016 on a high note, handily outperforming major benchmarks, according to data from Morningstar. And 2017 has started off well for the sector.

Give Them Some Time

Although there are ways to incorporate growth funds into your portfolio at almost any stage of your investing career, generally speaking, they are best suited for those who are not planning on retiring anytime soon, or at least not planning on needing to liquidate anytime soon. Because of growth funds’ added volatility, it’s best to have time on your side and plan on at least a 5- to 10-year investment horizon to lessen the chances of needing your funds in the middle of a market pullback.

Investing in growth stock can seem risky and, in a sense, it is. Often, the share prices of growing companies have priced in growth rates that may or may not materialize in a short time—or ever, for that matter. But investing in growth funds can allow you to spread your risk over a number of companies.