iShares Core U.S. Growth ETF Probably Deserved Worse
The iShares Core S&P U.S. Growth ETF (NASDAQ:IUSG) is a way to essentially play tech in the US. While the portfolio is somewhat skewed to megacap exposures, there are lots of other more explosive growers in the ETF. The problem with explosive growers is that as their cash flows are delayed due to recession risks, when the recession is caused by a rising reference rate and therefore higher discount rates, those delayed cash flows get heavily penalized. A decline rather in line with broader markets seems insufficient underperformance for the ETF, where perhaps weaker performance could come in the future as markets adjust. With higher risk free rates being absorbed as enduring by the bond market, equity markets should listen.
The top holdings of the IUSG do not look all that different from the general market.
It is skewed towards megacap exposures as one would expect, but more FANG names make it high up the list. Even in the smaller mid-cap and small cap holdings in this pretty large portfolio of 478 stocks, the tech exposures, the hallmarks of US growth, add up to a pretty substantial 41% of the overall portfolio. About half of the tech exposures are part of a fragmented bunch of very small holdings below 1% and these can be expected to be high growth, mid-cap and smaller cap companies.
The IUSG being a large portfolio has about 20% exposure to explosive growth tech players, many of which likely saw a substantial rise due to pandemic period digitalization. Our current economic regime is one of high rates, and this is expected for the longer-term by bond markets as evidenced by the yield curve which is mostly flat with both shorter and longer term Treasury yields lying at above 4%, even the 10Y Treasury yield at 4.022%. Risk free reference rates have gone from being below 1% to being 4% now for the typical equity horizon of between 5 to 10 years, not to mention equity risk premiums which have likely risen a little, although those will likely come back down as volatility reduces.
What’s the problem? We all know that higher discount rates penalizes future cash flows more harshly, but because of the compounding of the discount factor in more distant periods, distant cash flows are penalized much harder than sooner cash flows now as compared to before. Because of recessionary pressures such as higher rates and mortgage crimp, as well as demand destruction from inflation, growth rates are going to slow for a lot of tech companies despite solid secular backgrounds.
If you decompose the effect on valuations of a decline in growth rates for a year from 15% average to 5%, returning to 15% thereafter thus pushing back the continued growth a year, when risk free rates go from 1% to 4%, the discount to prices goes from being less than 10% to more than 20% in the 5th year including a GDP growth horizon value, where 5 years is a typical horizon period. The discount effect itself causes a 30% effect without even considering the cash flow pushback effect.
Currently the IUSG has traded down 30% YTD, which accounts for the rising discount rate only, and not the delay effect, which could deservedly bring down the higher growth parts of the portfolio down another 20%. That means maybe around 5-10% more downside just from the technical argument, and disregarding the potential for rates to go even higher than 4% for the next few years, which we think is possible although not certain. Overall, there is more downside in equities, but especially in ETFs like the IUSG.
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