You Think VUG Owns the Fastest-Growing Companies. That's Not Quite How It Works.

Investors buying shares of the Vanguard Growth ETF (NYSEMKT: VUG) probably think that they're buying the fastest-growing companies in the United States.

For the most part, that's true. The fund's selection criteria target companies using six separate growth-related metrics. The companies demonstrating the best composite of these factors make the final portfolio of growth stocks.

But part of the fund's selection strategy might not be what investors think it is. Four of the six factors are concrete numbers directly from the company's financial statements:

• Three-year historical earnings per share (EPS)
• Three-year historical sales per share
• Investment-to-assets ratio
• Return on assets (ROA)

The other two factors are forward-looking estimates:

• Expected short-term EPS growth
• Expected long-term EPS growth

In other words, stocks are at least in part getting selected based on what people think the company will do in the future. As we've seen in the past when analysts tried to predict what will happen in the future, it's not exactly science -- even for the market pros.

Image source: Getty Images.

VUG's definition of "growth" is based on future forecasts more than you think

In general, I'm OK with a fund's selection strategy using forward-looking measures. A company's future may look nothing like it did in the past. Balance sheet health could have changed. Company plans could have changed. Accounting for that should help provide a more accurate assessment of the company.

I find this especially useful for dividend growth stocks. If a company has increased its dividend every year for the past 15 years, it's highly likely that it'll continue doing so into the future.

Forecasting growth is a different story. The future could change much more suddenly and unexpectedly. Over the past few years, the artificial intelligence (AI) trade has rewarded almost any company that's invested heavily into its development and is starting to turn hype into results.

Analysts are likely basing their current forecasts on this trend continuing, which means the composition of the Vanguard Growth ETF is at least somewhat based on this as well. But what if the industry decides to collectively slow the development of AI tomorrow? Investment would probably slow significantly, and future growth estimates for the AI names would likely get revised lower, pulling share prices down with it.

If analysts get their forecasts wrong, the portfolio could be positioned incorrectly. Using forward-looking assessments in the selection process isn't necessarily a weakness. Actively managed funds do it all the time. However, it does reveal an exposure that Vanguard Growth ETF shareholders may not realize they have.

What VUG investors should do with this information

None of this necessarily makes this ETF one to avoid. In fact, combining backward- and forward-looking measures can be useful in certain cases.

However, it emphasizes the general idea that investors should know what they're buying. A lot of investors will probably be just fine with this, and that's OK. But at least part of the selection process is based on what analysts think will happen in the future. That requires the hope that they're not being too optimistic in their forecasts.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Morningstar Growth ETF. The Motley Fool has a disclosure policy.