After Surging 50.8% in 2023, Does This Top Vanguard ETF Have More Room to Run in 2024?

2023 was the year of megacap tech stocks. The Vanguard Mega Cap Growth ETF (MGK 1.87%) had a monster year, surging over 50% and outperforming the Nasdaq Composite and the S&P 500.

Here's why this exchange-traded-fund (ETF) is a good way to play a sustained rally in growth stocks, why it has the potential to be a foundational holding, and some of the risks of buying the fund now.

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Best-in-breed

The Mega Cap Growth ETF isn't nearly as large as some of Vanguard's massive funds. But with over $16 billion in net assets, it's still a relatively large ETF.

The fund's objective is simple -- target the largest growth stocks across all sectors. In today's market, most of the largest growth stocks are in the tech sector. But there are also behemoth financial growth stocks, like Visa and Mastercard, and fast-growing companies in the healthcare industry, like Eli Lilly.

The 10 largest holdings in the fund are these three companies plus the "Magnificent Seven" stocks -- Apple, Microsoft, Amazon, Alphabet, Meta Platforms, Nvidia, and Tesla.

Combined, these 10 stocks make up 64% of the total fund.

Data source: Vanguard.

There are some inherent pros and cons with such a concentrated allocation. On the plus side, the fund will do very well if the largest companies keep getting larger, which was the theme last year. But if there's a market correction or valuation contraction across these expensive names, the fund could suffer a brutal sell-off.

Managing risk

Nearly 80% of the fund is in the tech, communications, and consumer discretionary sectors -- a far higher concentration than the S&P 500.

Data source: Vanguard.

On the surface, such a concentrated sector allocation, as well as having so much of the fund in the 10 largest holdings, looks risky. Investing 100% of a portfolio solely in this ETF would be ultra-aggressive. But that's not the way ETF investing should work in practice.

The best way to use ETFs is to fulfill a specific need in your portfolio.

Let's say you want to invest half of your portfolio in growth stocks. Maybe 25% of the portfolio is in smaller, individual growth stocks you know well. And the other 25% goes into more stable, established growth stocks. Some of those may be individual holdings. But another portion, say 10%, could go into something like the Vanguard Mega Cap Growth ETF to provide a baseline, foundational holding with diversification across all the top names.

In this vein, the ETF is filling a defined role -- not acting as an all-or-nothing play on growth. The ETF checks all the boxes. It focuses mainly on the biggest winners, but still leaves 36% of the fund in other top growth companies like Adobe, Salesforce, and Netflix, as well as companies in other sectors with powerful brands like McDonald's, Nike, Starbucks, and more. So even though it is concentrated, there's still "enough" diversification in the ETF.

Best of all, the fund has a mere 0.07% expense ratio and is run by one of the most trusted institutions in the business: Vanguard. To put into perspective how small this expense ratio is, $10,000 invested in the fund incurs a mere $7 fee. Essentially, the fund charges a negligible price for a valuable service.

The power of earnings growth

The Vanguard Mega Cap Growth ETF is an excellent starting point for risk-tolerant investors looking to invest in the top growth stocks, including a high concentration in the Magnificent Seven. However, the fund is simply more expensive than it used to be. At a price-to-earnings (P/E) ratio of 39, the fund trades at a premium to the Nasdaq Composite.

When it comes to growth investing, the P/E ratio isn't typically the best metric out there because many companies are barely profitable or unprofitable. So, valuing a company solely on its last 12 months of earnings can be misleading. However, this ETF invests in established companies, almost all of which are profitable or could easily be profitable if they reduce their spending. So we'd expect the P/E not to be too high, yet it is because the fund soared so much last year.

For the P/E to come down, the fund either has to sell off in price or earnings must catch up. This is a tough spot for short-term investors because the fund would have to reach an even higher valuation, or earnings would have to grow faster than expected to see a spike in 2024. But for longer-term investors, buying quality companies, even at an expensive valuation, is almost always a good decision.

Earnings growth can work wonders over time. For example, let's say a stock has a P/E ratio of 40 but expects to grow earnings at 15% per year for the next five years. In that scenario, earnings will double in five years. If the stock goes nowhere, the P/E ratio would fall to 20 -- which would likely be far too cheap for a solid, high-growth company. Even if the P/E ratio compresses to 30, the investment will still produce a solid return of 50% over those five years.

The key takeaway is that earnings growth is more important than the present valuation of a company, or in this case, an ETF. It will be harder for the Vanguard Mega Cap Growth ETF to repeat last year's performance. But it could still be a worthwhile investment over the next three to five years as long as the top holdings grow earnings.