Key Points

  • Traditional growth indices, designed as the inverse of value, have delivered negative excess returns and failed to provide faster growth in earnings per share (EPS). Active growth managers, who track growth indices, have likewise underperformed the market.
  • Companies that invest aggressively to grow assets and sales despite a low return on capital perform poorly, attributable to negative relative growth in EPS. Companies with a high return on capital and more disciplined growth strongly outperform, attributable to high relative growth in EPS.
  • A smart beta growth strategy, by investing in profitable companies with conservative investment practices, can diversify value strategies while delivering a strong positive excess return from sustainably faster growth in EPS.


Investors have long used the “style box” to diversify their equity portfolios by allocating to a mix of growth and value funds. As intended, diversifying by style has reduced tracking error. Unfortunately, it hasn’t delivered the hoped-for outperformance. While value funds have outperformed the market, growth funds have underperformed.1

Value indices are built on strong theoretical foundations and have provided a long history of positive excess returns. Traditional growth indices, constructed as the inverse of value, lack a robust theoretical foundation and have provided a long history of negative excess returns. Even worse for growth investors, active growth managers have delivered underperformance along with high fees.2

Can investors find a simple systematic growth strategy to diversify their value funds that also provides a positive excess return? Yes! We show in this article that a smart beta growth strategy—investing in companies with sustainably high earnings-per-share (EPS) growth, as identified by high profitability and conservative investment—can diversify value indices, while also delivering a positive excess return.

The Failure of Growth Funds
In 1993, Fama and French synthesized previous academic work on the sources of equity returns to create the famous three-factor model: market, value, and size. Soon thereafter, “growth” came to be interpreted as the inverse of value. The logical assumption was that investors, in an efficient market, will set higher stock prices relative to book value in recognition of stronger future growth in EPS.

Following this interpretation, growth indices were created as the inverse of value indices; they were simply indices of expensively priced stocks. We now know, however, that more expensive stocks persistently underperform cheaper stocks. Unsurprisingly, traditional growth indices, inspired by this definition of growth, have duly underperformed.

Active managers endeavor to identify unrecognized or underappreciated companies likely to deliver future growth in EPS that more than compensates for any price premium. Unfortunately for the investors in these funds, active growth managers, much like growth indices, have generally failed to deliver positive excess returns. Active growth managers, on average, underperformed the market by nearly 60 basis points a year from January 1991 to June 2013—and this is before fees! 3

Smart Beta
Smart beta seeks to deliver well-researched, systematic sources of excess return through transparent, low-cost investment vehicles. Informed by the Fama–French (2015) five-factor model, we explain how to create a smart beta growth strategy by combining the two new factors—profitability and investment—Fama and French recently added to their three-factor model.

Today, profitability and investment are well-known factors. The excess returns associated with these factors have been thoroughly documented in earlier papers.4 In this article, we demonstrate that the fundamental source of the excess returns delivered by profitability and conservative investment can be attributed to sustainably faster growth in EPS, the very attribute that growth funds attempt to provide. From this finding, we show these two new factors can be combined to construct a smart beta strategy that delivers persistent outperformance through high growth in EPS.