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This ETF Offers High Quality Mid-Cap Stocks at a Bargain

Don’t ignore the middle.

Mid-cap stocks are special. These companies typically grow their earnings at a faster clip compared with large companies but are on firmer financial footing compared with small companies. This often makes them attractive acquisition targets. These factors, among others, have helped mid-cap stocks outperform both their larger and smaller brethren over the long term. From Jan. 31, 1995, through Dec. 19, 2019, the S&P MidCap 400 Index outperformed the S&P 500 and the S&P SmallCap 600 indexes by 195 and 76 basis points annualized, respectively.

IShares Core S&P Mid-Cap ETF IJH is an outstanding way to invest in U.S. mid-cap stocks. As one of the cheapest and most broadly diversified market-cap-weighted funds in the mid-blend Morningstar Category, it earns a Morningstar Analyst Rating of Gold.

This fund tracks the S&P MidCap 400 Index, which offers broad, market-cap-weighted exposure to U.S. mid-cap stocks. The resulting portfolio accurately represents the composition of the U.S. mid-cap market segment. The fund's sector exposures are similar to the mid-blend category average, though it tends to have a smaller market-cap orientation than most of its peers.

Market-cap-weighting reflects the market's collective wisdom. Market prices tend to do a good job reflecting information that's available to the public, making it hard to beat the market, especially over long term. However, over shorter time periods, investors may overreact and drive prices either too high or too low. Market-cap weighting will increase or decrease exposure to stocks accordingly. That said, the fund's broad diversification and low-cost advantage far outweighs this minor disadvantage.

The portfolio is broadly diversified as it holds about 400 stocks, while the category average represents about 500 holdings. The top 10 positions represent about 7% of assets. This effectively diversifies firm-specific risk.

BlackRock charges an ultralow 0.07% fee for this fund. This cost advantage has translated into strong category-relative performance over the long term. Over the trailing 10 years through June 2019, the fund outperformed the category average by 208 basis points annualized while exhibiting slightly greater risk. On a risk-adjusted basis, the fund outperformed the mid-blend category average. Overall, this fund should continue to enjoy a durable long-term edge over many of its competitors because of its low expense ratio and lower-than-average cash drag.

Fundamental View Mid-cap stocks tend to have higher long-term growth potential than large-cap stocks. They tended to grow earnings at a faster clip than the stocks in the S&P 500 over the trailing 10 years through July 2019. Furthermore, mid-cap stocks tend to exhibit slightly lower volatility than small caps. Over the trailing 10 years through July 2019, IJH exhibited an annualized standard deviation of 15.03% versus 16.66% for iShares Core S&P Small-Cap ETF IJR.

This broad market-cap-weighted portfolio is compelling. In addition to harnessing the market's collective wisdom, it mitigates turnover, which helps minimize transaction costs and makes the index easier to track. By being fully invested, the fund has a minimal cash drag, which helps its category-relative performance during bull markets, though this can hurt in bear markets.

Indexing in mid-caps presents a unique advantage. Although there is potential for sector concentration, the risk of stock-specific concentration is significantly mitigated by the fact that companies that become too large will graduate out of the mid-cap index and into the large-cap index. Additionally, companies that experience a significant decline in market capitalization may drop out of the mid-cap index. With the top five holdings (Steris STE, NVR NVR, Zebra Technologies ZBRA, Teledyne Technologies TDY, and Alleghany Corp Y) only accounting for 3.5% of the portfolio, the fund is well-diversified and provides broad exposure to mid-cap stocks at a low cost.

The fund's sector exposures are currently similar to the category average. It does not constrain its sector allocation, and this may lead to overallocation to some sectors as they become more richly valued and have lower expected returns. At times, the fund may have greater exposure to sectors such as financial services and consumer cyclicals than to defensive sectors such as utilities. Consumer cyclical and financial services tend to be correlated with the overall economy, which presents a macro risk, while more-defensive sectors such as utilities are less sensitive to the business cycle.

This fund has had strong long-term risk-adjusted returns versus the category average. Over the trailing 10 years from July 2009 through June 2019, it outperformed the category average by 208 basis points annualized while exhibiting slightly greater risk. On a risk-adjusted basis, the fund outperformed the mid-blend category average. Much of this relative outperformance can be attributed to the fund's cost advantage, lower-than-average cash drag, and poor stock selection among the fund's active peers.

Portfolio Construction The fund employs full replication to track the market-cap-weighted S&P MidCap 400 Index. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment. Unlike mechanical rules-based indexes, the fund's index is maintained by a committee, which has some discretion in its selection process. As such, size is not the sole determinant of index inclusion. Stocks in this index must have a market cap between $2.4 billion and $8.2 billion and must pass a financial viability hurdle to be added in the index. The index committee updates these ranges as necessary to keep the portfolio representative of the U.S. mid-cap market. While there isn't a comprehensive set of rules that determines which stocks make the cut, new constituents must have positive earnings over the most recent quarter and year. Also, the index has a high free-float requirement, which should help it avoid the least liquid stocks.

Fees The fund carries a low fee of 0.07%, which is among the lowest in the category and a fraction of the 0.96% median levy that its mid-blend peers charge. During the trailing three years through June 2019, the fund lagged its benchmark by 7 basis points per year, comparable to its fee.

Alternatives Investors seeking alternatives to IJH have several options, including Silver-rated SPDR S&P Mid-Cap 400 ETF MDY, Gold-rated Schwab U.S. Mid-Cap ETF SCHM, and Gold-rated Vanguard Extended Market ETF VXF.

Similar to IJH, MDY tracks the S&P MidCap 400 Index. However, with an expense ratio of 0.24%, MDY is more expensive and hamstrung by an inflexible legal structure, which disallows securities lending and dividend reinvestment.

SCHM tracks the Dow Jones U.S. Mid-Cap Total Stock Market Index, which is designed to minimize transaction costs. It applies generous buffers to mitigate unnecessary turnover. SCHM charges a low 0.04% expense ratio.

VXF (0.07% expense ratio) tracks the S&P Completion Index, a broad market-cap-weighted index that represents nearly every U.S. stock outside of the S&P 500. The fund is intended to complement S&P 500 holdings. It reduces transaction costs by sampling among the smallest, least liquid stocks, but it still holds nearly every stock in the index.

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