What it means
Growth funds sit at one end of a spectrum with income and value funds at the other. The managers look for businesses with expanding markets, rising revenue and reinvestment plans, and they accept paying a high multiple of current earnings on the expectation that earnings will catch up.
That approach produces a particular return pattern. Growth funds tend to outperform sharply in expansions and fall harder in downturns, because a valuation built on future earnings is more sensitive to changing interest rates and confidence than one built on current cash flows.
They come in several shapes: large-cap growth funds holding established fast-growing companies, small-cap growth funds holding earlier-stage businesses, sector funds concentrated in technology or healthcare, and aggressive growth funds that take the most concentrated positions. Risk rises as you move down that list.
For a business audience the practical relevance is often in company pension and treasury decisions. A pension committee choosing a default investment option is deciding how much growth exposure to give employees with thirty years to retirement compared with those with three.
Costs matter more than most investors expect. Growth funds trade more actively than index funds, and an expense ratio of 0.9% against 0.1% compounds into a substantial difference over decades even when the manager picks well.
In practice
Real-world examples.
Example
A 29-year-old employee choosing between pension options selects a fund allocating 85% to growth equities, on the basis that thirty-five years to retirement gives ample time to recover from downturns. Her colleague two years from retiring picks a conservative option with a fraction of that exposure.
Example
A founder who has just sold part of her stake places $400,000 into a diversified large-cap growth fund rather than concentrating it in a handful of technology shares. She accepts a lower ceiling on returns in exchange for not depending on any single company.
Example
A charity's investment committee reviews its growth fund after a year in which the fund fell 19% while the broad market fell 11%. The committee retains the holding, having confirmed the strategy had not changed and that the fall was consistent with how growth strategies behave when interest rates rise.
Think of it
“Growth fund buys fast-growing companies-betting on future earnings growth.
Formula
Calculation
Net Return = Gross Return - Expense Ratio
Ending Value = Starting Investment x (1 + Net Annual Return)^Years
An investor puts $25,000 into a growth fund. The fund's underlying holdings return 11% a year over five years, and the fund charges an annual expense ratio of 0.9%.
Net annual return = 11% - 0.9% = 10.1%
Ending Value = $25,000 x (1.101)^5 = $25,000 x 1.6178 = $40,446
Had there been no fee at all, the same 11% gross return would have produced $25,000 x (1.11)^5 = $42,126. The 0.9% annual charge therefore cost $42,126 - $40,446 = $1,680 over five years, on an investment of $25,000. Over twenty years the same fee gap compounds into a far larger sum, which is why fees deserve as much attention as past performance.Case study
Seen in the real world.
Fernhollow Community Foundation is a fictional organisation used for this illustrative example. It held an endowment of $12 million and needed to draw 4% a year, or roughly $480,000, to fund its grant programme.
The board had placed 90% of the endowment in an aggressive growth fund after several strong years. When markets fell 24% in a single year, the endowment dropped to about $9.1 million, and drawing the same $480,000 now meant selling 5.3% of a much smaller pot, exactly the position an endowment is designed to avoid.
The foundation restructured rather than abandoning growth investing altogether. It moved to 55% growth funds, 30% bonds and 15% cash and short-term deposits, holding two full years of grant funding in the liquid portion so it would never again be forced to sell equities in a falling market. Long-run expected returns came down slightly, but the grant programme became predictable, which the trustees decided was the point of the endowment in the first place.
Watch out
Common mistakes.
- Choosing a growth fund on last year's return. Growth strategies are streaky by nature, and the best-performing fund of one year is frequently among the worst of the next.
- Assuming a growth fund is diversified simply because it holds many shares. Many hold heavy concentrations in a single sector, so two growth funds can behave almost identically in a downturn.
- Ignoring the expense ratio because returns look strong. Fees are charged whether the fund gains or loses, and a percentage point of annual cost compounds into a very large amount across a working lifetime.
Questions
People also ask.
What is the difference between a growth fund and a value fund?
A growth fund buys companies expected to increase earnings quickly and accepts high valuations to do so, while a value fund buys companies trading below what their current assets and earnings appear to justify.
Do growth funds pay dividends?
Usually very little, because the companies they hold reinvest profits into expansion rather than distributing them, so returns come almost entirely from share price appreciation.
Who should avoid growth funds?
Anyone who may need the money within a few years, since a growth fund can easily fall 20% or more in a bad period and needs time to recover.
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