The technology and healthcare sectors stand apart for bringing new products, ideas, and services to market. They also accelerate change in other industries. This inventive spirit gives them prime real estate in growth benchmarks, which tend to be more heavily exposed to the parts of the market that are growing fastest, with the most change and innovation.
Most investors want to add some of these growth elements to their portfolio — but may be overlooking a few important nuances around exposures that could help get them there.
1. Benchmark basics
Investors who want to benefit from growth should be mindful of the way benchmarks are set, the cycles that feed them, and how they correlate to various sectors.
Every index is reconstituted on its own calendar, and the timing of this calendar matters. Since we’re talking about growth in this article, we’ll focus on the Russell 1000 Growth benchmark. Russell reconstitutes its indexes annually on the last Friday in June.
What is the benchmark? The Russell 1000 Index is the “parent” of the Growth (and Value) benchmark. It is a large-cap core index of approximately 1,000 of the largest companies in the U.S. equity market. Its Growth and Value benchmarks, which are style subsets of the larger index, each have several hundred holdings, with some stocks held in both.
How are the benchmarks determined? The Russell 1000 Value Index is determined by one metric: price/book, which is the stock’s market price divided by its book value. Book value is determined by a company’s assets minus liabilities, divided by the number of shares available to common stockholders.
The Russell 1000 Growth Index, by contrast, is determined by two metrics: IBES forecast medium-term growth and sales per share historical growth (trailing 5 years). Individual positions are determined according to their market caps.
How are the benchmarks reconstituted? During the annual reconstitution process, the benchmarks are completely rebuilt to reflect the market landscape at that time.
How does this affect my portfolio decisions? This reconstitution process can lead to “concentration” at both the sector and stock level. In simple terms, this means that certain benchmarks will be more heavily weighted in certain sectors or stocks.
This chart reflecting the 2020 benchmarks shows three typical sector concentrations in Growth and Value. It illustrates how different the sector exposures can be between the two benchmarks.
We see in this table that roughly 24% of the Value index is concentrated in two sectors — financials and energy. Similarly, roughly 45% of the Growth index is concentrated in technology. By contrast, technology only constituted about 9.7% of the Value benchmark and financials and energy together only constituted 2% of the Growth benchmark.
What does this mean to investors? It means that if you want exposure in technology, you might not be getting it if your investment is largely in the Value universe. It also means that the Value index is likely to be much more highly impacted by volatile commodity prices than Growth.
This concentration in sectors has a big impact on the performance of each benchmark. Since about one fifth of the Value benchmark is in financials, the performance of finance’s largest industries (banks and insurance) will have an outsized impact on the Russell 1000 Value compared with Growth. Meanwhile, the technology exposure in Russell 1000 Growth means that when technology sees strong performance during a period, the Growth index will likely outperform the Value index.
Anything else I should keep in mind about benchmarks? A key issue investors should keep in mind is what happens when major events — like the COVID-19 pandemic — are timed such that they aren’t reflected in the benchmark. Think of the difference in the global situation between June 2019, when the Russell 1000 Growth was reconstituted for the coming year, and March 2020, when the pandemic lockdowns began. Massive market shifts, like the lockdown-driven dependence on cloud technology or the closure of physical retail, would not (and could not) be reflected in the 2019 benchmark.
2. The even bigger picture behind the big picture
When we look at companies for our growth holdings, we strive to look at the bigger picture behind the very important picture provided by benchmarks.
In the broadest terms, growth tends to be equated not so much with specific sectors or industries, but with innovation. Companies and sectors that innovate or benefit from innovation cycles are more likely to fall into the growth universe, alongside structural advantages like size that are likely to drive ongoing growth and competitive strength.
Semiconductors are a good example of how companies in one sector can have big, lasting impacts on multiple other sectors. The semiconductor industry is known for its “chip cycles.” We are in a cycle now where automotive companies need chips in order to offer navigation and in-car apps. Semiconductor companies are boosted by this demand from other industries for these innovations while simultaneously boosting innovation in other industries.
The cloud is another example of this mutuality. Prior to the pandemic, the retail sector wasn’t the boon to cloud providers that it is today. In a social-distancing/lockdown scenario, though, if a retailer doesn’t have an online presence or is unable to access its data on the cloud, it can be difficult to do business at all. So technology provides an important benefit to the retail sector, and the retail sector accelerates growth in the tech companies that enable it to continue to do business.
Our growth team seeks exposure to companies that are going to be able to use innovation to continue to grow over the long term and companies that enable other companies to grow over the long term as well. This analysis traces the logical stepping stones of the innovation chain to identify companies that enable an innovation, benefit from an innovation, or offer other factors like size or capacity that empower dominance for durable growth.
Active management makes a difference
While benchmarks are highly important, a key benefit of active management is that you benefit from fund managers who track not only the benchmarks but also the opportunities that arise from new and emerging-market dynamics every single day.
Since March of 2020, we’ve seen shifts in the economy and trends that we at Putnam believe may offer long-term, durable growth opportunities. These shifts include broad themes such as increased digitization, a growing number of businesses with direct sales channels, and more scaled, capital-light business models. Huge industries, like healthcare and parts of the industrial and consumer complex are ripe for technological change. We seek to own businesses that are enabling and benefiting from this change.
The growth profiles for many of the companies we hold in our Growth Opportunities Fund are supported by the kinds of durable tailwinds we describe above. We also specifically incorporate prior cycle downside capture into our risk framework. This approach has served the strategy well in the past, and we would expect it to continue to do so into the future.
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