Mid Cap ETFs for Style and Effect

Thursday, October 8, 2009

Mid-sized US companies are perennially overlooked but will always remain a key tool for style investing. And ETFs tracking mid cap have performed relatively well during the recent turmoil.

One strategy with mid cap is to overweight coming out of a bear market. Another strategy is to judge mid cap's prospects based on its industry weightings. Consider the following mid cap exposures vs. large and small cap (for September 2009):

Mid CapLarge CapSmall Cap
Consumer Discretionary15%9%15%
Consumer Staples5%11%3%
Energy8%12%5%
Financials18%16%21%
Health Care10%13%12%
Industrials13%10%16%
Information Technology16%19%18%
Materials7%4%5%
Telecommunications Services1%3%1%
Utilities7%4%4%

Overweighting consumer staples companies and underweighting consumer discretionary is not the right mix if consumers pull back spending (but it is ideal if consumers don't). Overweighting materials is partially a play on volatile commodities. Overweighting utilities should offer stable income. Overweighting health care reduces the play on government health intervention, for better or worse. Overall we see average volatility in the mix except for worrisome exposure to consumer spending which should be tight-fisted.

Mid cap enthusiasts can tick off a variety of factors in favor of mid cap ETFs. Ignored by cyclical traders and used mostly by buy-and-hold investors, mid cap seems less volatile than small cap and often less bid-up than large cap. Mid cap companies are good candidates for acquisition by larger ones, and when this happens shareholder receive a tidy premium. A quirk of index construction plays in mid cap's favor: the largest mid cap companies often get a speculative boost just before they are promoted to large cap index, once again to the benefit of shareholders.

In most years mid cap will perform in between small and large cap but so far this year mid cap has outperformed both (using Vanguard funds here to demonstrate):

(Legend: VO=mid cap; VB=small cap; VV=large cap)

It would be a mistake to see mid cap as diversification for small or large cap. Correlation is generally high as the graph suggests, and other asset classes will do a better job. By the same token there is little risk of a US equity investor concentrating more on mid cap.

Careful attention to size definitions of mid cap companies by ETFs is critical to accurate use of this asset class. Major plain-vanilla, low-cost mid cap ETFs with their size range of holdings include:

  • Vanguard Mid-Cap ETF (AMEX:VO): stocks ranked 301-750
  • iShares S&P MidCap 400 (NYSEArca:IJH) stocks ranked 501-900
  • iShares Russell Midcap ETF (NYSEArca:IWR): stocks ranked 200-800
  • SPDR Dow Jones Wilshire Mid Cap ETF (AMEX:EMM): stocks ranked 501-1000
  • SPDR MidCap ETF (AMEX:MDY): stocks ranked 501-900

Fees range from Vanguard's tight-fisted .13% per year to as much as .25%, but all are reasonable. There is little expense drag to passive size investing in ETFs.

Where does mid cap start and end? Definitions vary by provider. For many investors the S&P 500 is synonymous with large cap, while the next 500 or so smaller stocks are mid cap and the next 2000 or so are small cap. Knowing how much to buy is crucial for over- or underweighting. In this case the first 500 stocks represent about 75% of the US stock market, the next 500 represent about a bit less than 15% and the next 2000 represent less than 10%. A size-neutral portfolio will allocate in these proportions.

Precise numbers for how much to invest in particular ETFs to remain neutral depends on each provider's definition of size boundaries. Allocations can be calculated by summing market capitalization and weightings of holdings of a provider's small, mid and large cap funds vs. the aggregate. Style investing takes a bit of work.

For investors seeking liquidity, IJH and EMM are good candidates. They themselves are quite liquid and complement S&P 500 ETFs which have tight bid-ask spreads due to their enormous trading volume, competitive fees and ample study by Wall St. analysts. They also are easy to follow in the news.

Note that EMM does not complement its sister products SPDR Dow Jones Wilshire Mid Cap ETF (AMEX:ELR) and SPDR Dow Jones Wilshire Mid Cap ETF (AMEX:ELR). ELR contains stocks ranked 1-750 by size and is complemented by small cap ELR which handles stocks ranked 751-2500. Using EMM with them causes double exposure on mid cap stocks. EMM's true purpose is complements S&P 500 ETFs such as SPY, which is useful for many investors.

In addition to these four plain-vanilla size-based ETFs, there are numerous mid cap ETFs also targeting growth or value:

  • iShares Morningstar Mid Core ETF(NYSEArca:JKG): 0.25% annual fee
  • iShares Morningstar Mid Growth ETF(NYSEArca:JKH): 0.3% annual fees
  • iShares Morningstar Mid Value ETF(NYSEArca:JKI): 0.3% annual fees
  • iShares Russell Midcap Growth ETF(NYSEArca:IWP): 0.25% annual fees
  • iShares Russell Midcap Value ETF(NYSEArca:IWS): 0.25% annual fees
  • iShares S&P MidCap 400 Growth ETF(NYSEArca:IJK): 0.25% annual fees
  • iShares S&P MidCap 400 Value ETF(NYSEArca:IJJ): 0.25% annual fees
  • Rydex ExpressShares S&P MidCap 400 Pure Growth ETF(AMEX:RFG): 0.35% annual fees
  • Rydex ExpressShares S&P MidCap 400 Pure Value ETF(AMEX:RFV): 0.35% annual fees
  • Vanguard Mid-Cap Growth ETF(AMEX:VOT): 0.13% annual fees
  • Vanguard Mid-Cap Value ETF(AMEX:VOE): 0.13% annual fees
  • SPDR Dow Jones Wilshire Mid Cap Growth ETF(AMEX:EMG): 0.25% annual fees
  • SPDR Dow Jones Wilshire Mid Cap Value ETF(AMEX:EMV): 0.25% annual fees

For traders there are a handful of leveraged funds. They typically deliver two times the daily return of an index (or the inverse for the short funds), less costs of rolling over monthly futures. These deliver a bit more leverage than borrowing on margin from a broker, they cost less per unit of leverage, and losses are limited to your investment in the ETF (no late-night margin calls). A good deal all-in-all but strictly for traders.

  • ProShares Ultra Russell MidCap Growth ETF(AMEX:UKW): 0.95% annual fees
  • ProShares Ultra Russell MidCap Value ETF(AMEX:UVU): 0.95% annual fees
  • ProShares UltraShort Russell MidCap Growth ETF(AMEX:SDK): 0.95% annual fees
  • ProShares UltraShort Russell MidCap Value ETF(AMEX:SJL): 0.95% annual fees
  • Rydex ExpressShares 2x S&P MidCap 400 ETF(AMEX:RMM): 0.7% annual fees

Unlike large and small cap categories, however, only a few ETFs use fundamental financial ratios to beat popular indexes. These are high quality and at reasonable prices:

  • RevenueShares Mid Cap ETF(NYSEArca:RWK): 0.54% annual fees
  • WisdomTree MidCap Dividend ETF(NYSEArca:DON): 0.38% annual fees
  • WisdomTree MidCap Earnings ETF(AMEX:EZM): 0.38% annual fees

Co-founder of indexfunds.com, author of two books on investing, and founder of ETFzone.com, Will has been writing on indexing issues for 8 years. He holds an MBA from the University of Texas at Austin.