Growth stocks have powered the U.S. stock market year-to-date, with the largest growth stocks, known as the Magnificent Seven, leading the way. Calls for a recession are beginning to wane, and innovative technologies like artificial intelligence promise a bright future. It’s easy to see why growth stocks could continue to climb.
But valuations are becoming stretched again in short order. Higher interest rates are still just starting to work their way into companies’ capital structures, geopolitical risk remains high, and there remains a high degree of uncertainty in the market. Time and time again, investors get caught chasing performance only to see market trends shift shortly thereafter. Avoiding these three ETFs can help investors stay focused on the road ahead instead of being caught looking in the rearview mirror.
3 Growth ETFs to Avoid in 2023
The first ETF on my list is Invesco QQQ Trust, ticker QQQ. There’s no way around the fact that this ETF is a top performer. It ranks among the top-percentile funds in the large growth Morningstar Category over the past 10 years. But it selects stocks based on whether they list their shares on Nasdaq or not, an arbitrary-at-best strategy.
Nasdaq holds many of the past decade’s best performing stocks, which is great for longtime QQQ investors but has led to a problem with concentration at the top of its portfolio. In July, over 50% of the portfolio was invested in just seven companies. This forced Nasdaq’s hand, and a special rebalance was required to diversify the top-heavy portfolio.
Past success may be this strategy’s downfall. High concentration increases risk. And most of QQQ’s impressive year-to-date return has come from expanding valuations rather than improved fundamentals. QQQ’s average price/book ratio is almost 50% higher than the Russell 1000 Growth Index, making it increasingly difficult for QQQ to continue outperforming this benchmark.
The second ETF on my list is ARK Innovation ETF, or ARKK. This is an ETF that burned plenty of investors that chased 2020 returns into 2021 and 2022. ARKK turned a corner this year, getting back near the top of the leaderboard with big returns year to date. But the essence of ARKK has changed—the number of holdings in its portfolio is nearly half that of prior highs in 2018 and 2021. The portfolio shrank down to just 28 holdings earlier this year. The fund’s willingness to drop half of their stocks calls into question the long-term innovation and growth capabilities of the companies it holds.
Long-term growth assessments are obviously subject to change, but this portfolio has never stayed under 50% turnover in a year since its 2015 inception. Here at Morningstar, we often warn about the pitfalls of performance-chasing, and Cathie Wood’s trading record with respect to Nvidia is a primary reason why. Over the past five years, ARKK has given up on Nvidia and bought it back in multiple times, tending to sell out right before the stock took off. Most recently, this occurred when ARKK dropped Nvidia from its portfolio in January, shortly before Nvidia tripled in price.
ARKK’s investment strategy claims to target companies geared for long-term innovation and disruption, but ARKK’s quick trigger in adding and dropping stocks seems antithetical to its mission. And increasing concentration means a heavy dose of risk. More diversified growth funds offer a better chance of success for the rest of 2023.
The last ETF on my list is AI Powered Equity ETF, or AIEQ. AI is the defining theme of 2023, with incredible progress being made with ChatGPT and other AI applications. But AI is still at an early stage.
ETFs using AI to pick and weight stocks have done poorly overall. In fact, their portfolio management style raises red flags for which we often take human portfolio managers to task, including style drift and overtrading. AIEQ has always had a high turnover ratio, but last year, it went berserk, turning over its entire portfolio 17 times.
Investors could look past this red flag if performance reflected AI’s ability to buy and sell at the right time. Unfortunately, AI is like the rest of us, unable to solve the market-timing puzzle. Perhaps that won’t be the case one day, but AI-managed portfolios like AIEQ have yet to prove themselves worthy of investors’ hard-earned dollars.
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