A multifactor ETF investing approach for mid cap stocks

While U.S. mid-cap stocks have provided solid returns over the long term, some investors miss out because they underweight the asset class and focus more on large- and small-cap companies. A multifactor investing approach in an exchange-traded fund (ETF) structure may make sense for mid-cap exposure due to these stocks’ unique characteristics, opportunities, and challenges. 

Mid-cap stocks, which are roughly classified as those with a market capitalization of $2 billion to $20 billion, are often overlooked but have outperformed small- and large-cap stocks over the past 25 years. Superior earnings growth has provided a tailwind for mid caps.

Investors trying to time their style exposure to mid-cap growth and value funds hurt their performance, based on money-weighted returns, capturing less of the category average return than investors who stuck with mid-cap blend strategies. Therefore, it could make sense for investors to simplify their allocations to mid caps. Money-weighted returns measure the performance of the average investor in the fund, based on net inflows and outflows of the fund.

Due to poor timing of buy and sell decisions, mid-cap growth and value fund investors captured only about 85% and 73% of the category return, respectively.

Yet, mid-cap blend fund investors fared the best with a 90% capture rate of category return. This is a key point. Style-timing decisions in mid caps reduced returns, which provides a strong case for moving away from targeted value and growth allocations and toward the center of the style box (blend).

When deciding on an active or passive approach for individual asset classes, it may make sense to look at both the propensity of managers to outperform the index and the magnitude by which outperforming managers generate better results than the index.

Among the U.S. equity style boxes as defined by Morningstar, mid-cap blend and mid-cap value rank at the very bottom in terms of propensity to outperform, at just 27% and 29%, respectively, while less than half of mid-cap growth managers outperform, at 44%. Meanwhile, in terms of magnitude, outperforming managers beat the index by the smallest degree in mid cap, with the top third of managers actually underperforming in mid-cap value and blend.¹

Given that active manager selection is most difficult in mid caps, investors may benefit from alternative approaches such as smart beta.

Due to the strong performance of mid caps and embedded gains, fund investors can be hit with capital gains distributions even if they don’t sell shares. Mid-cap funds overall had negative returns in 2018, yet over 90% of mid-cap funds distributed capital gains.²

The ETF structure can reduce the potential for capital gains, which are a drag on after-tax returns. The ETF wrapper can also help address capacity concerns, since many top-rated active mid-cap funds are closed because their asset bases have grown too large.

Putting it all together, an ETF that employs a multifactor approach may solve some of the challenges and capture the opportunities in U.S. mid-cap stocks. A multifactor ETF may be able to target a wide range of mid-cap stocks to access the breadth of the category’s opportunities, while emphasizing factors such as smaller cap, lower relative price, and higher profitability that academic research has linked to higher expected returns.

1 Source: Morningstar, as of 12/31/18. 2 Source: Morningstar, as of 12/31/18.