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To hear marketers for midcap stock mutual funds and exchange-traded funds tell it, these not-too-big, not-too-small companies are supposedly just right for investors nowadays.
It’s a nice story. Too bad it’s not true.
There have been times when midcap stocks were the best-performing of the size categories, and those are the ones the marketers emphasize. But you can always slice and dice the data in ways to support a predetermined conclusion. .
The most definitive answer about midcaps’ prospects comes from analyzing performance over the longest period possible. And that long-term perspective doesn’t support the midcaps’ Goldilocks story.
Consider the most comprehensive performance database covering the different size categories, compiled by University of Chicago professor Eugene Fama and Dartmouth College professor Ken French. From the beginning of 1927 through the end of last year, according to their data, a portfolio containing the 30% of U.S. stocks with the smallest market capitalizations produced an 11.7% annualized return, versus 9.6% annualized for a portfolio containing the 30% of stocks with the largest market caps. Fittingly, the midcaps (the middle 40% of the distribution) were in the middle with an 11.5% annualized return. (See the chart, below.)
This pattern has held up over the past 20 years, as you can also see in the chart. So there is no urgent reason to think the U.S. market has changed in ways that suggest midcaps will do better in the future than in the past.
Furthermore, according to veteran investor Lawrence Tint, “There is no theoretical basis for expecting any difference in risk-adjusted returns between the small-, mid-, and large-cap sectors.” Tint is chairman of Quantal, a risk-management firm for institutional investors; until 2000, he was U.S. CEO of BGI, the organization that created iShares (now part of investment management giant Blackrock).
To illustrate his point, Tint proposed two hypothetical cap-weighted index funds, one of which contains stocks whose first letters are between A and N and the second containing stocks whose names begin with the letters O through Z. Since the so-called FAANG stocks are large-cap stocks that are part of the first index, it likely will outperform the second whenever the FAANG stocks are doing well — and to underperform when not.
By the same token, there will be times when the best-performing stocks fall in the midcap category, and others when the worst performers will do so. Tint points out that, though a more plausible story can seemingly be told about size than the first letter of a stock’s name, it is no less artificial a basis for categorization.
Are mid-cap managers more likely to beat the market?
While on the subject of midcap stocks, it’s worth mentioning that they currently appear to be special for another reason: an especially large percentage of institutional midcap managers beat their benchmarks in 2018. According to the recently released S&P Dow Jones Indices’ 2018 Year-End SPIVA Institutional Scorecard, about 56% of all midcap managers outperformed last year, but among managers focusing on midcap-growth the percentage was a stunningly high 82%.
Yet 2018 was a fluke. In other years since 2009, midcap managers so consistently lagged their benchmark that, even after accounting for their 2018 outperformance, just 19% of them beat their benchmarks over the past decade through 2018. The percentage among all midcap growth managers was smaller, at 18%.
One reason that years like 2018 are especially generous to midcap mutual funds, Tint explains, is that there is no precise definition of a midcap stock. Different midcap benchmarks contain different stocks. So there is ample opportunity for a midcap manager benchmarked to one midcap index to come out way ahead (or behind) another.
Take the FTSE Russell and S&P midcap indices, for example. Stocks in the FTSE Russell Midcap Index have a median market cap of $8 billion, double that of the S&P 400. The largest stock in the FTSE Russell index has a market cap of $73 billion, versus $15 billion for its S&P counterpart. These are big differences.
The bottom line? Stocks in this midcap fairy tale don’t all live happily ever after. That’s good advice for any investment, but especially so for midcaps: understand what you’re investing in, and beware of marketers telling stories.
Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at mark@hulbertratings.com
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