The Many Flavors of Mid-Cap Growth Funds

You may be wondering why a Morningstar analyst would write that it's important to understand how a fund in the mid-cap growth category invests money. It's simple: The fund buys mid-cap growth stocks, right?

Well, yes and no. Consider two facts that complicate the picture. 1) When Morningstar fund analysts talk to managers who run mid-growth funds, we quite often hear: "I'm not sure why Morningstar puts my fund in the mid-cap growth category." 2) Maybe more strikingly, the average mid-cap growth category member currently devotes only 39% of assets to stocks that reside in the mid-cap growth section of the Morningstar style box.

There's plenty of misunderstanding about Morningstar's style-based categories for stock funds. An important point to remember is that we don't "put" funds into categories so much as they "fall" there. A fund's categorization is based on objective fundamental data, namely its underlying holdings. Diversified domestic-equity funds are assigned to one of the nine style-box categories based on the 36-month trailing average of the fund's style box history. Obviously, if a fund has consistently fallen into the large-blend corner of the style box for three years, it will go into the large-blend category. If a fund's style box has shifted once or more, it will be assigned to the category where it has spent the most time.

The details of the Morningstar style box are more complex, but a basic explanation should suffice. Each of the 5,000-plus stocks in the domestic universe gets plotted vertically by its market capitalization and horizontally by a combination of five value traits (such as price/earnings ratio) and five growth traits (such as historical cash-flow growth). Morningstar defines large caps as holding 70% of the assets of the total domestic market, mid-caps as holding 20% of assets, and small caps 10%. Currently that means that large caps are firms with market caps greater than $8.5 billion, small-caps have market caps below $1.5 billion, and mid-caps are in between. Roughly one third of each market cap band are value stocks, one third are core stocks, and one third are growth stocks. A fund's equity style box is based on the asset-weighted average of its holdings' style and size scores. A good way to think of this is that almost all funds invest in stocks of one or more market-cap range and style range, but each fund has an epicenter, or center of gravity, that falls into one of the nine squares of the style box, thereby defining the fund's style box every time we receive a new list of portfolio holdings.

You'll note that the name of a fund and its prospectus objective aren't a part of Morningstar's category definition. Furthermore, we have no category designation for funds that invest across a wide range of equities--offerings that are sometimes labeled by fund companies as go-anywhere, multicap, or all-cap funds. Morningstar treats such funds the same way it treats those with more strict market-cap limits. As one might guess, a lot of funds that end up with mid-cap style boxes have all-cap mandates.

So the mid-growth category is a grab-bag of sorts, containing more than 300 funds. The average mid-growth fund spreads roughly $500 million over roughly 100 holdings, devoting about 26% to its top 10 holdings. But there are a lot of different types of funds. The category includes behemoths such as   T. Rowe Price Mid-Cap Growth (RPMGX) (with its $12 billion in assets) and  Fidelity Mid-Cap Stock (FMCSX) (with its 400-plus holdings). It also includes a portfolio with just 20 holdings,  Pin Oak Aggressive Stock (POGSX), and nearly 100 funds that have less than $50 million in assets.

As noted above, it's the range of investments that mid-cap growth funds make that is so important for investors to understand. One might think that 39% of assets is a very small amount to invest in a fund's "home" style, but it's not unusual. Of the style-specific categories, large-growth funds have the heaviest current weighting devoted to their "home" style at 45%, while mid-blend funds devote only 21% of assets to mid-cap core stocks.

What all this means is that if you're searching for exposure to mid-cap firms that are showing solid growth, you can't just pick a mid-cap growth fund with a nice record and low expenses and be done with it. Selecting a fund always takes more effort and care than that. You have to know how a fund comes to reside in the mid-growth category. 

Is it an all-cap and multicap growth fund like  Calamos Growth (CVGRX),  Brandywine (BRWIX), or  Janus Orion (JORNX)? Or is it a core mid-cap fund that leans enough to the growth side to land in Morningstar's mid-growth category, such as  Hartford Midcap (HFMCX),  AIM Capital Development , or  PIMCO CCM Mid Cap .  Or is it a fund that really concentrates on mid-cap growth stocks, like  Turner Midcap Growth ,  Vanguard Mid Cap Growth (VMGRX), or  Buffalo Mid Cap (BUFMX).

In other words, you need to know what you want, what you're getting, how it fits in your overall investment portfolio, and finally that it's strategy is effective and repeatable. For looking at a strategy, sizing up the fund's holdings doesn't go far enough. You'll want to look at a fund's Web site and literature to see if there's a good explanation of strategy, or you can read the Morningstar Fund Analyst Report.

There's one final thing to consider when it comes to carrying a strategy into the future: fund size. At Morningstar we've written quite a bit about the problems that funds with large asset bases face, and we hope that this explanation of the mid-growth category puts some of these concerns into perspective. If there are only 250 or so mid-cap growth stocks, now ranging from Harman International's  $8.5 billion market capitalization down to Quicksilver Resources'  $1.5 billion market cap, it gets hard to focus on mid-growth stocks and still meaningfully differ from the market when you have, say, $10 billion in assets. As Russ Kinnel noted recently, most mid-cap managers that shutter their doors do so around $3 billion. Only a handful of mid-cap growth funds with assets above that level remain open to new investment, but when looking at a fund, think ahead: Would steady asset growth cause this fund to have to buy more stocks, buy bigger firms, or both?