My Top ETF to Buy for 2023 (and It's Not Even Close) | The Motley Fool (2024)

Exchange-traded funds (ETFs) have been around since 1993 but actively managed ETFs didn't take off until around 2008. Since then, these funds have gained quite a following and, according to BlackRock, ETFs now make up about 12% of equity assets in the U.S. Data suggests that ETFs will likely grow their share of equity assets in the coming years.

The Vanguard Growth ETF (VUG -0.96%), which is the largest growth ETF by net assets, suffered a catastrophic 33.2% drawdown in 2022. It was the largest calendar-year drawdown since the fund's inception in January 2004.

The valuation of the components of the Vanguard Growth ETF, combined with the fund's track record and the reliability of Vanguard, make it a compelling buy for 2023. Here's why.

Growth at an exceptional value

The top 10 holdings of the Vanguard Growth ETF are the usual mega-cap suspects of the technology, communications, consumer discretionary, and financial sectors. Yet you may notice that the forward price-to-earnings (P/E) ratios of companies like Apple, Microsoft, Alphabet, Tesla, and Home Depot are all reasonable, especially given their historical valuations.

Data sources: Vanguard, YCharts.

And although a stock like Amazon has a sky-high P/E ratio, the company could easily cut back on spending, and the stock would look far cheaper. In fact, Amazon is currently trading around its lowest price-to-sales ratio and price-to-operating-cash-flow ratio in a decade.

The best of both worlds

The Vanguard Growth ETF is unique because the top 10 holdings make up 46.6% of the fund -- which is high for a diversified fund with 247 stocks. But I would argue that this concentration in top names is ideally suited for long-term investors.

Having just under half the fund in 10 well-known companies that dominate their respective industries provides an excellent foundation. Investors can count on these companies to make it through an economic downturn and likely take market share in the process.

Meanwhile, a little over half of the fund is in 237 growth stocks. Some of these companies could lose most, if not all, of their value. But some of them could also double or triple in the coming years, especially now that valuations have compressed. In this vein, the other half or so of the Vanguard Growth ETF is like a diversified venture capital fund that is spreading its bets across a wide variety of opportunities.

In sum, the Vanguard Growth ETF is incredibly balanced because it is heavily weighted in blue chip growth stocks without compromising exposure to smaller-cap names.

A better option than funds like the Ark Innovation ETF

Contrast the composition of the Vanguard Growth ETF with another popular growth fund, like Cathie Wood's Ark Innovation ETF (ARKK 1.00%), and you may be surprised at the holdings and their valuations.

Data sources: Ark Invest, YCharts.

The majority of Ark's holdings are unprofitable or have premium valuations relative to the market. They are also much smaller, higher risk/higher potential reward bets on paradigm-shifting technology and innovation.

The Ark Innovation ETF could easily outperform the Vanguard Growth ETF over time. But the risk/reward of the Ark Innovation ETF, even after falling 67% in 2022, just doesn't seem nearly as attractive as the Vanguard Growth ETF because it is predicated on a few unproven companies doing well instead of proven companies at reasonable valuations doing well.

What's more, the Vanguard Growth ETF has an expense ratio of just 0.04% compared to the Ark Innovation ETF expense ratio of 0.75%. 0.75% is a far cry from the costs that mutual funds used to charge decades ago. But the scale of Vanguard and its trillions of dollars in assets under management allows it to charge practically nothing -- a significant benefit for the retail investor.

Using ETFs to your advantage

ETFs can be excellent tools for narrowing your investment preference toward a type of investment (growth versus value or income), a particular theme, or even a sector while maintaining a diverse set of holdings.

For many risk-tolerant folks who want to have a majority growth-orientated portfolio, it may be best to use a more stable fund like the Vanguard Growth ETF as a starting point and then individually invest in your favorite higher-risk/potentially higher-reward growth stocks with a reasonable allocation. That way, you can still leave room to invest in individual stocks without overly exposing yourself to a harmful amount of risk.