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ETFs

An Inexpensive Gold-Rated Mid-Cap Fund

Schwab US Mid-Cap ETF accurately represents the U.S. mid-cap equity market and is among the cheapest available.

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Since its inception in January 2011, the fund has tracked the Dow Jones Total Stock Market Mid-Cap Index, a broadly diversified index that accurately represents the U.S. mid-cap market. The index holds the next 500 largest stocks by market capitalization after the largest 600 are assigned to the large-cap segment of the Dow Jones Total Stock Market Index.

Most of this fund’s holdings have not yet established durable competitive advantages and tend to be riskier than larger stocks. But the fund effectively diversifies firm-specific risk. Its top 10 holdings represent about 4% of assets, compared with the mid-blend Morningstar Category average of 24%. This fund’s average market capitalization is about 15% smaller than the category average.

The index relies on others to accurately price its holdings, so the fund is fully exposed to the potential excesses of the market. But it also effectively reflects the collective views of active investors. Compared with the category, it has larger real estate and utility sector weightings, and lower exposure to healthcare and technology stocks. Low turnover is a key advantage of the fund’s market-cap-weighted approach because it translates into lower transaction costs. The fund’s average during the past five years of 17% is less than one fourth of the category average.

The fund outpaced the mid-cap blend category by 1.8 percentage points annually from its inception in January 2011 through September 2017. The fund’s risk-adjusted returns, as measured by its Sharpe ratio, also landed in the category’s top quintile over the same period. Much of this relative outperformance can be attributed to the fund's sizable fee advantage and smaller-than-average cash drag. Because the fund remains fully invested, it may suffer larger drawdowns during market downturns, but during bull markets the strategy should pay off.

Fundamental View Each index provider defines mid-cap stocks slightly differently, but they generally account for about 7%-20% of the U.S. market's total market capitalization after the largest stocks, which make up about 70%-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 over the long run. They tend to be riskier and less profitable than large-cap stocks because they have less-established competitive advantages and are more sensitive to the business cycle. But they may compensate investors with higher return potential and diversification benefits. Over the very long term, mid-cap stocks have generated higher returns than their larger counterparts. Small-cap stocks are riskier still than mid-cap stocks, but have compensated investors with slightly higher returns over the long haul.

The case for indexing mid-cap stocks boils down to two considerations: costs and whether the index represents its peers’ opportunity set. Like most of its index peers, this fund charges a much lower fee than its actively managed counterparts. And because its portfolio is representative of its active peers, it should do better than average net of fees over the long term. Additionally, its market-cap-weighting approach keeps turnover low, which mitigates transaction costs. But there are some drawbacks. Market-cap weighting relies on market participants to incorporate new information into stock prices. It also increases the fund’s exposure to stocks as they become larger and more expensive, and reduces its exposure to names as they become smaller and cheaper, which may have higher expected returns. Finally, the fund is always fully invested. That can help performance during bull markets, but hurt during bear markets.

This broad, market-cap-weighted portfolio offers efficient, well-diversified exposure to mid-cap stocks. Its top 10 holdings represent around 4% of the portfolio. Because the Dow Jones U.S. Total Stock Market Mid-Cap Index is not widely followed, the market impact costs to move securities into and out of the index are lower than the costs some of its more popular peers incur. The underlying index introduced new liquidity requirements in June 2015. Now, 10% of a stock’s shares must trade publicly before it can be added to the index.

The index uses buffering rules to reduce unnecessary turnover and transaction costs. At the annual reconstitution, currently held stocks are favored over new stocks that may better fit the fund’s size criteria. The index still invests in mid-cap stocks, but isn’t forced to trade stocks that barely cross the index’s market-cap size thresholds. Market-cap weighting allows market prices to determine the portfolio’s sector weightings, which differ a bit from the category average. The fund has greater real estate, consumer discretionary, and industrial sector weightings and less exposure to technology, financials, and consumer staples sector stocks.

Portfolio Construction The fund tracks an index that effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting its Positive Process Pillar rating.

The fund tracks the Dow Jones U.S. Total Stock Market Mid-Cap Index, which ranks U.S. stocks by market capitalization, excludes the largest 600 stocks, and targets the next largest 500. When the index reconstitutes each year in September, current holdings that rank between the largest 401st and 1,100th places by market capitalization are included first to reduce unnecessary turnover. Like most index peers, the fund adjusts its holdings’ weightings to reflect free-float market capitalization. In June 2015, the index began requiring new constituents to have 10% of its shares publicly traded to be included. New stocks must also pass a minimum trade volume threshold. Current holdings do not have to pass these liquidity hurdles.

Fees The fund levies a 0.05% fee, which is lowest in the category, warranting a Positive Price Pillar rating. This expense ratio is a fraction of the 0.99% median levy its Morningstar Category peers charge.

During the trailing three years through September 2017, the fund lagged its benchmark by three basis points per year, less than its average fee over the same period. This implies the fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio-management techniques and securities lending.

Alternatives

Investors looking for a dedicated U.S. mid-cap index fund have several attractive options to choose from, including

Silver-rated

For investors that wish to complement a large-cap holding in one fund, Gold-rated

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.

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