NEW YORK - Large-cap funds have long served as core holdings for individual investors, and several years of outstanding performance have put small-cap funds in the spotlight. But you rarely hear about the benefits of owning stocks in the middle market.
That might seem surprising when you consider that mid-caps have performed exceptionally well in recent years. For example, if you'd invested in the Vanguard Mid Capitalization Index (VIMSX) five years ago, you would have earned annualized returns of about 9 percent. In contrast, the Vanguard Small Cap Index (NAESX) has earned annualized returns of slightly more than 6 percent, while the large-cap Vanguard 500 (VFINX) has lost an average of 2.6 percent each year.
For people looking for broad exposure to all the cap sizes, one solution might be a total stock market index fund, such as one that tracks the Wilshire 5000 - a basket of virtually every publicly traded company on the domestic market. But this index is constructed on a market-weighted basis, which means larger stocks have the greatest influence on its performance. Over the last five years, the Vanguard Total Stock Market Index (VTSMX) has posted an average annual loss of 1.5 percent.
For this reason, some money managers think the best way to build a diversified equity portfolio is to skip mid-caps altogether, and focus on the edges of the market, where stocks are most likely to outperform. It's not that mid-caps perform poorly; in fact, they're usually quite consistent. But their lack of big highs doesn't add much pizazz, said Richard Buck, managing editor of FundAdvice.com, a publication of Merriman Capital Management in Seattle. The real key to a diversified investment strategy is holding securities that behave very differently from one another.
Small stocks, which have market caps of $2 billion or less, and large stocks, which have market caps of $10 billion or more, tend to perform quite differently from each other during various market cycles. If you hold them both, you'll generally see strong returns from one or the other, and as long as you rebalance carefully - taking profits from the one that's outperforming and reinvesting in the one that lags - you're likely to come out ahead over the long term. Rebalancing is essential when it comes to buying low and selling high.
"We just think, dollar for dollar, our investors will get more return per unit of risk if they skip the mid-caps and stick with the large- and small-caps," said Buck. "If you had a perfectly balanced portfolio, mid-caps aren't going to give you anything extra. They're just going to give you more of the middle."
That said, if you're going to own just one fund, or you don't think you're up to rebalancing on a regular basis, you'd probably be better off owning a mid-cap fund than a total market fund. Of course, few financial professionals would recommend owning just one fund. If you do find yourself shopping for a mid-cap, you should think carefully about what you hope it will do for you and your portfolio.
Mid-cap funds tend to fall into two camps, said Christine Benz, associate director of fund analysis with Morningstar Inc. The first group is dedicated to investing in mid-cap stocks, which can be useful if you're building a portfolio laddered across different equity asset classes. The second type lands in the mid-cap category by happenstance, because the managers have latitude to invest wherever they find opportunities.
"Some of the very best managers have their roots in the mid-cap value box," Benz said. "Traditionally mid-cap value and blend has been a very rich area for stock pickers."
When dealing with a free-wheeling manager, however, you must watch the fund's portfolio carefully to make sure it doesn't start to overlap with your other holdings. For example, the Oakmark Select I (OAKLX) fund was a Morningstar mid-cap value pick until manager Bill Nygren shifted its focus to larger stocks. While it's still a fine fund with a strong track record, its median market cap of $13.7 billion puts it outside the mid-cap category.
Some mid-cap picks from Morningstar:
-T. Rowe Price Mid-Cap Value (TRMCX). With a five-year trailing return of 16.29 percent, this fund has a great track record, low volatility and a moderate expense ratio of 0.91 percent. Manager David J. Wallack, at the helm since 2001, looks for reasonably priced companies with strong managements. The average market cap is $4.63 billion.
-Ariel Appreciation (CAAPX). This fund invests more conservatively than its peers, and currently leans heavily into the large-cap space, with an average market cap of $9.84 billion. It has trailing five-year returns of 13.33 percent. While strong on most counts, Morningstar notes its 1.15 percent expense ratio could be lower. Manager John Rogers Jr. founded the firm in 1983, and also runs the small value Ariel Fund.
-TCW Galileo Value Opportunities (TGVOX). This fund's tendency to invest in turnaround stocks can cause some volatility, but it has a strong track record, with five-year trailing returns of 16.88 percent. Co-manager Susan Suvall has been with the firm for two decades, and has led this fund with Nicholas F. Gulluccio since its inception in 1997. Expenses are low, at 0.98 percent, and its average holding has a market cap of $3.7 billion.
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