A Top-Rated Choice for Diversified, Low-Cost Exposure to U.S. Mid-Caps

During the 10-year period ended Sept. 30, 2016, IJH returned 8.99% per year, outstripping the U.S. mid-blend Morningstar Category average by 2.2 percentage points per year. Much of this relative outperformance can be attributed to the fund's sizable fee advantage. At 0.07%, IJH's annual levy is a tiny fraction of the 0.97% median fee charged by its category peers.

Broad diversification is an intrinsic advantage of funds tracking broad market-cap-weighted indexes. However, market-cap weighting has its pluses and minuses. It can be a beneficial approach in momentum-driven bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. It can also lead to significant sector and single-security concentration, as witnessed at the height of the technology bubble. So market-cap-weighted indexes' greatest strength is arguably also their Achilles' heel.

Low turnover is another key advantage of a fund tied to a market-cap-weighted benchmark. Lower turnover equates to lower transaction costs and a lesser likelihood of taxable capital gains distributions. IJH's median annual turnover was 14.0% during the trailing 10 years. This compares with a median figure of 77.3% for its category peers.

Fundamental View Each index provider defines mid-cap stocks slightly differently, but they generally account for around 7% to 20% of the total market capitalization of the U.S. market after the largest stocks, which make up about 70% to 80% of the market in aggregate. Morningstar defines mid-caps as the 20% of the market after the largest 70%, which roughly corresponds to the next-largest 600 or so stocks after the largest 300.

Mid-cap stocks have been in the sweet spot of risk-adjusted performance since 1926. Although they have historically had a higher return than large caps, they have also had a higher volatility and a higher beta, or more procyclical movement with the market. But the higher return has compensated investors for the increased risk. While small caps had even higher returns, mid-caps have had a slightly better ratio of return to risk. For this reason, many investors chose to give an overweighting to mid-cap stocks. Yet there is no guarantee their past outperformance will persist.

The outperformance of mid-cap stocks during the past 15 years has caused them to look expensive relative to large-cap stocks. As of October 2016, this fund's mid-cap stocks were trading at a price/prospective earnings ratio of 20.2 while the less-volatile large caps in the S&P 500 were trading at a more reasonable 19.0. The dividend yield on stocks on mid-caps is about 1.8% versus about 2.3% for the S&P 500.

The valuation premium of mid-cap stocks could be justified in part based on analyst expectations for faster earnings growth. According to consensus analyst estimates, earnings for the stocks in the fund are expected to grow at 10.2% during the next three to five years, compared with 8.5% for stocks in the Russell 1000. 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. Mid-cap stocks may be attractive acquisition targets for large companies. Particularly in this environment of slower economic growth, large companies may look to acquire smaller companies to fuel growth.

Mid-cap stocks are less likely to have sustainable competitive advantages than large-cap stocks and tend to be less profitable. Morningstar equity analysts rate fewer mid-cap stocks, but of those they do rate, just 8.2% of the assets are rated as having wide Morningstar Economic Moat Ratings, compared with 48.4% for rated large-cap stocks. Mid-cap stocks also have more debt, with a higher debt/capital ratio than large caps. During the trailing 12 months through September 2016, mid-cap stocks generated a lower average return on invested capital (5.4%) than those in the Russell 1000 Index (11.2%).

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. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting a Positive Process Pillar rating. This fund has a smaller average market cap ($4.4 billion) than the mid-blend category average ($6.6 billion) and the S&P 500 ($73.8 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. This ETF follows a full replication strategy, essentially holding all 400 stocks in the index. Like most funds, IJH enjoys the flexibility afforded by the Regulated Investment Company structure, whereas the more heavily traded ETF in this category,

Fees This fund levies a low fee of 0.07%. The fund's expense ratio is a fraction of the 0.97% median levy taken by its category peers, meriting a Positive Price Pillar rating. During the five-year period ended Sept. 30, 2016, the fund lagged its benchmark by 11 basis points per year. Given that the fund's expense ratio averaged approximately 0.17% per year during that span (it's been steadily reduced), this reflects high-fidelity tracking performance.

Alternatives There are two other ETFs that track the same index as IJH. The first is Bronze-rated SPDR S&P MidCap 400 ETF MDY. While MDY trades more than IJH, its liquidity advantage over IJH has eroded to the point where they are both comparably liquid. In addition, not only is MDY more expensive (0.25% expense ratio), but it is organized as a unit investment trust, which is a more restrictive legal structure. Vanguard S&P Mid-Cap 400 ETF IVOO charges 0.15% but is much less liquid than IJH and MDY. Like all of Vanguard's U.S. ETFs, IVOO is a separate share class of a Vanguard mutual fund.

Among mid-cap ETFs that track other indexes, two competitive options are Gold-rated

Investors looking for a complement to a large-cap U.S. stock fund might consider Gold-rated

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