Splitting Growth And Value Leads To A Worse Return

It is common practice for some investment advisers to divide U.S. stock index funds equally into growth and value index funds. This practice adds nothing to a portfolio and actually reduces return. It also adds complexity where none is needed, which perhaps is the goal of the adviser.

I’ve looked at thousands of portfolios created by investment advisors over the years, and an uncanny number of them routinely split their U.S. equity allocation between a value index fund and a growth index fund. For example, I came across one portfolio with a the large cap U.S. equity allocation split of 9.5% in iShares Russell 1000 Value ETF (IWD) and 9.5% in iShares Russell 1000 Growth ETF (IWF). I wonder if this manager ever checked to see if there was any benefit to doing this, because a simple analysis of this strategy shows that there isn’t one.

Using Russell U.S. index data going back to 1979, I looked at the return of the large-cap Russell 1000 Index and compared it to the return of a split Russell 1000 Value Index and Russell 1000 Growth Index ETF. One split portfolio assumed an equal allocation to value and growth starting 1979 and never rebalanced. I call this the buy-and-hold portfolio (Russell B&H 50/50). The second portfolio rebalanced each year back to an equal split between growth and value (Russell 1000 Rebal 50/50). Figure 1 highlights the annualized returns through June 2013.

Figure 1: Comparing Annualized Returns of the Russell 1000 to Split Russell 1000 Value and 100 Growth Indexes
From January 1979 through June 2013


Source:  Russell Investments

As Figure 1 illustrates, simply holding the entire Russell 1000 index and NOT splitting into two equal value and growth style indexes had the best annualized return. The split index performance erodes further after three main costs.

Any investor can buy the iShares Russell 1000 ETF (IWB) and pay a 0.15% in annual expense ratio each year. Contrast this with the 0.20% charged by both the iShares Russell 1000 Growth ETF (IWF) and the iShares Russell 1000 Value ETF (IWD). This puts a split ETF strategy automatically in the hole by 0.05% each year.

In addition, the rebalanced portfolio has to be reallocated back to its 50/50 split each year. This further adds to the cost due to commissions and trading spreads.

Finally, there is a potential tax consequence. Shares of the outperforming style index fund are sold to buy the underperforming fund. This creates a realized capital gain and a tax event for portfolios held in a taxable account.

Before passing sentence on this strategy, I took a look at the risk of each portfolio using standard deviation. If the volatility of the split portfolios were lower than the volatility of the single Russell 1000 index, then perhaps splitting is justified. Figure 1 highlights the annualized standard deviation of each strategy through June 2013.

Figure 2: Russell 1000 and Split Russell 1000 Value and 1000 Growth Index Annualized Standard Deviation
From January 1979 through June 2013


Source:  Russell Investments

This analysis does not help explain why an adviser would implement a split strategy rather than just buying the entire Russell 1000 Index. The buy-and-hold portfolio (Russell 1000 B&H 50/50) had the lowest return and the highest risk as measured by standard deviation. The annually rebalanced portfolio (Russell 1000 Rebal 50/50) had a slightly lower return and slightly higher risk than the all-inclusive Russell 1000 Index.

There was no benefit to splitting the Russell 1000 Index into equally allocated growth and value on either a nominal return or a risk reduction basis.  Simply buying and holding the Russell 1000 Index in its entirety is the best option.

This raises the question: Why do some advisers advocate using a split strategy?

My view is that they do it solely for marketing purposes. Equal weighing value and growth index funds adds a layer of complexity to a portfolio and this impresses unknowing clients. In addition, a portfolio with more funds looks more robust that a portfolio with less funds. Clients may feel they’re getting their money’s worth with the adviser. Finally, either growth or value will always outperform the broad market, so the adviser will always has something to crow about in a client meeting.

Keep your portfolio costs low by not slicing and dicing portfolios needlessly. Equally allocating between growth and value index funds adds nothing to a portfolio and actually reduces return. If your adviser is sold on the split strategy, then perhaps it’s time to get another adviser.