What is a growth fund?

A growth fund is a kind of investment vehicle – typically either a mutual fund or exchange-traded fund (ETF) – that focuses on companies with higher-than-average growth potential. Growth funds are popular with investors because of their potential to deliver attractive returns over time, but they do come with some drawbacks, in particular greater volatility, due to the stocks they own.

Here is what a growth fund is, the types of growth funds and how they work.

How a growth fund works

A growth fund invests in the stocks of companies that are poised to grow revenue or earnings at above-average rates. In a bid to expand, growth companies tend to invest a substantial portion of their cash flow into their business, either in the form of new facilities, acquisitions, research and development or some combination of these and other elements. Fast-growing companies have the potential to generate higher returns for investors as they expand their operations.

This approach stands in contrast to funds focused on other types of stocks, such as value funds that buy only stocks trading at a discount or dividend funds that invest solely in dividend stocks. While growth stocks may pay dividends, they generate returns mainly by appreciating in value.

Growth funds can be packaged in two different forms: as a mutual fund or as an ETF. In many cases, the funds may end up owning many of the same stocks, but there are some key differences that separate the two. ETFs trade during the regular trading day like stocks, while mutual funds trade only after the market closes. Mutual funds are actively managed and tend to have higher fees than ETFs, and ETFs are considered more tax-efficient because of the way they are structured and traded.

Types of growth funds

Growth funds are classified mainly by the size of the companies in the fund:

• Small-cap growth funds: These funds invest in the stocks of small companies, and these companies are riskier than larger companies, because they don’t have the same depth of financial resources or established businesses compared to larger companies. The best small-cap funds also have higher potential returns than large-cap funds.
• Mid-cap growth funds: These funds invest in the stock of mid-size firms that are more mature and less risky than small-caps but still offer sizable growth opportunities. Potential returns here sit between those of small-cap funds and large-cap funds.
• Large-cap growth funds: These funds invest in stocks of large companies that are much more established than smaller rivals and that have deep financial resources and still-growing businesses. The greater stability of these companies means that returns are likely lower than for smaller companies, but the best large-cap funds still perform well.

Growth funds tend to focus on one size of company rather than owning all types together in a single fund. A fund management company may have one type of fund for each company size, giving investors the convenient ability to gain exposure to the firm size they want in one fund. So if you want just small-cap stocks, buy the small-cap fund and you’re ready to roll.

Should you invest in growth funds?

Growth funds can deliver attractive long-term returns to investors, however it’s important to understand the potential drawbacks before making a decision:

• Expense ratio: The fund management company charges a fee for managing the fund called an expense ratio. Expense ratios on ETFs tend to be lower than those on mutual funds, and the fee is based on a percentage of assets invested in the fund. Expenses might typically range from 0.03 percent to 1 percent, corresponding to annual fees of $3 to $100 for every $10,000 managed. Pay careful attention to the expense ratio. An expense ratio is considered low if it falls within the 0.03 percent to 0.2 percent range. Any expense ratio higher than 1 percent is considered high.
• Volatility: Growth funds tend to be more volatile than other types of funds because the underlying stocks are more volatile. The smaller the company, the more volatile it tends to be. Small-cap funds will typically be more volatile than large-cap funds so investors should prepare for the high volatility and match their risk tolerance accordingly.
• Time horizon: Because of the funds’ volatility, investors need to have a longer time horizon to invest in them. That is, investors need to be able to ride out the short-term volatility to reach the potentially high long-term returns available here. If you need money in the short term, it’s better to stick with one of the best short-term investments.
• Low dividends: Growth funds are focused on capital appreciation rather than dividends, so if you need a substantial dividend, they may not be the best place for your money. That said, they may still pay a dividend, but investors will find a higher payout in other investments such as real estate investment trusts (REITs) or dividend funds.

Growth funds can be an excellent investment as they offer the potential for higher returns over time. If you have decades to invest in them – or even just a decade – you can enjoy some of the market’s best returns.

Bottom line

Growth funds can be an attractive investment, especially over the long term, if you’re able to allow them to work their compounding magic on your money. However, keep in mind that these investments tend to be more volatile and have higher risk when compared to other investments. If you need dividend-producing assets or money in the short term, consider other short-term investments like money market accounts or high-yield savings accounts.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.