Efficient Exposure to Mid-Cap Stocks

 IShares Core S&P Mid-Cap (IJH) is not the oldest or most heavily traded ETF tracking the S&P MidCap 400. That distinction belongs to  SPDR S&P MidCap 400 ETF (MDY). But IJH has a structural advantage that gives it an edge. Like most funds, IJH enjoys the flexibility afforded by the Regulated Investment Company structure, whereas the more heavily traded ETF in this category, MDY, is organized as a unit investment trust, which is a more restrictive legal structure that precludes securities lending and dividends reinvestment. During the past decade through November, MDY has lagged the S&P 400 MidCap by 0.34 percentage points annualized, compared with just 0.13 percentage points for IJH. While traders continue to prefer MDY due to its heavy volume and deep options market, a lower expense ratio and structural advantages make IJH a better option for long-term investors in our view. Asset growth in this fund has improved liquidity to the point were trading costs between the two funds are comparably low.

IJH provides low-cost exposure to U.S. mid-cap stocks. Paired with an appropriate investment in large-cap stocks, it can serve as a suitable core holding and help form a diversified allocation to U.S. equities. The fund offers broad diversification across industries and individual companies in the mid-cap market segment. It is designed to fit between the large-cap S&P 500 Index and S&P SmallCap 600 Index to cover the vast majority of the U.S. equities market with minimal holdings overlap. Active investors might also use this fund to tactically overweight mid-cap stocks.

Mid-cap stocks tend to be more volatile than their large-cap counterparts as they are less likely to sport economic moats--or sustainable competitive advantages. As such, they tend to be more sensitive to the business cycle. The volatility of return on mid-cap stocks as measured by standard deviation was 17.7%, more than 2 percentage points greater than that of the S&P 500 Index during the past 15 years. Investors have been rewarded for this risk. During that time, the S&P MidCap 400 Index has returned 10.0% annualized, compared with 4.7% for the S&P 500. However, the returns of mid-cap stocks relative to their larger counterparts can vary drastically over time. 

U.S. mid-caps have historically provided only minor diversification benefits to large-cap stocks. During the 15 years through November 2014, the S&P MidCap 400 Index was 0.92 correlated with the S&P 500. Mid-caps have behaved more similarly to U.S. small-cap equities, exhibiting a correlation of 0.94 to the S&P SmallCap 600 Index during the same time period.

Fundamental View
While mid-cap stocks have outperformed large caps over the past 15 years, they are lagging large caps by about 5 percentage points so far in 2014. Yet they still look expensive relative to large-cap stocks. As of mid-December, the mid-cap stocks in the S&P MidCap 400 Index that our analysts cover appear slightly overvalued, trading at a price/fair value ratio of 1.06, while the less volatile large caps in the S&P 500 trade at a lower price/fair value ratio of 1.03.

The dividend yield on stocks in the S&P MidCap 400 Index is about 1.5% compared with about 2.1% for the S&P 500 Index. They are also trading at a higher price/forward earnings ratio (20) than the S&P 500 Index (18). That valuation premium can be justified in part based on analyst expectations for faster earnings growth among mid-caps. Consensus analyst earnings growth over the next three to five years is 11% for mid-cap stocks compared with 10% for stocks in the S&P 500. However, if that growth does not materialize, mid-cap stocks have further to fall.

Not only are mid-caps more expensive than large caps, but they are also lower quality. Mid-cap stocks are less likely to have sustainable competitive advantages and they tend to be less profitable. Over the trailing 12 months through November 2014, the fund’s holdings generated a lower average return on invested capital (10%) than those in the S&P 500 Index (15%). Rich valuations and pronounced vulnerability to rocky economic conditions are good reasons to not have an overweighting in mid-caps, which make up about 15% of the U.S. equities market.

On the positive side, mid-cap stocks may be attractive acquisition targets for large companies, which are currently sitting on a lot of cash. Particularly in this environment of slower economic growth, large companies may look to acquire smaller companies to fuel growth. An investment in mid-cap stocks may give investors access to a faster-growing segment of the market without as much volatility as small caps.

Portfolio Construction 
IShares Core S&P Mid-Cap seeks to match the holdings and returns of the S&P MidCap 400, which gives it a broadly diversified portfolio of mid-cap stocks across industries and the value-growth spectrum. Morningstar currently defines mid-cap stocks as those with a market cap between $3.8 and $17.2 billion. This fund has a smaller average market cap ($4.8 billion) than the category average ($7.7 billion) and the S&P 500 ($73 billion). The index covers approximately 7% of the market, whereas the large-cap S&P 500 covers approximately the largest 75%. The committee that selects the constituents for the S&P indexes has some discretion to exclude companies based on quality factors, so unlike some other indexes, size is not the sole determinant of inclusion in the index. This exchange-traded fund follows a full replication strategy, essentially holding all 400 stocks in the index. 

Fees 
This fund levies a 0.12% expense ratio, below the 0.25% expense ratio of MDY and below the 1.26% expense ratio of the average mid-blend mutual fund. This low fee gives the fund a sustainable edge against its peer group. 

Alternatives
Among mid-cap ETFs that track other indexes, two competitive options are  Vanguard Mid-Cap ETF (VO) and  Schwab US Mid-Cap ETF (SCHM). The Vanguard fund has a higher average market cap than IJH, at $10.7 billion, and charges an expense ratio of 0.09%. The Schwab fund has an average market cap of $6.1 billion and has the lowest expense ratio at just 0.07%. 

Investors looking for a complement to a large-cap U.S. stock holding might consider  Vanguard Extended Market ETF (VXF), which costs 0.10% a year. It invests in essentially all U.S. stocks except for those in the S&P 500. So in addition to the stocks in IJH, VXF includes small- and micro-cap stocks.

 

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