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On July 30, Fidelity Viewpoints presented the case for mid-cap stocks in “Don’t Overlook Mid-Caps.” They argue that mid-caps “historically performed well coming out of a recession,” trade at the lowest valuations since 1990-1991, and trade below historical valuations such as price to sales.

Long-term investors have moved away from asset allocation strategies in recent months, due to increased correlation between assets. During the bull market, analysts debated the merits of small caps versus large caps, growth versus value. Those discussions still take place, but they’ve been drowned by the collapse in equity, commodity and real estate prices. The difference between two market capitalization groups wasn’t as big a concern for investors when their decision was “to invest or not to invest.” Furthermore, industry- and country-specific news has dominated, with commodities, technology, emerging markets and financials grabbing headlines.

Assets move in the same direction when they’re driven by common factors, especially at the height of credit bubbles and during the panic sell-off phase. Whether we’re out of the woods or not, the reality is that any current bubble or subsequent sell- off is much less likely to be such a highly correlated event. Separation has already begun to take place—a quick check of our Performance Table shows that coal, China, India, Singapore and international real estate were among the best performing ETFs, with returns between 30 and 50 percent, while homebuilders, domestic real estate, defense and some financials had returns of 10 percent or less.

The difference between asset classes was smaller, with PowerShares Dynamic Mid Cap Growth (PWJ) up 7.50 percent in percent advance in Rydex S&P SmallCap 600 (RZV). Throwing out those two outliers, however, the difference fell to just 12 percent between SPDR Dividend (SDY), up 10.06 percent, and Rydex S&P MidCap 400 Pure Value (RFV), up 22.93 percent.

Among the mid-cap funds, value produced the biggest winners but also held several of the worst performers, while mid- cap blend and mid-cap growth had less variation.

Different indexing styles account for the performance variation, most clearly seen in industry weights. Ironically, the worst performing mid-cap ETF, PowerShares Dynamic Mid Cap Growth (PWJ) has the largest allocation to technology, with about one-third of assets in hardware and software. Technology was one of the better-performing sectors, but PWJ wasn’t able to take advantage of it.

The top six performers had two representations each of growth, blend and value. SPDR Dow Jones Mid Cap Growth (EMG) and Rydex S&P MidCap 400 Pure Growth (RFG); Vanguard Extended Market (VXF) and RevenueShares MidCap (RWK); iShares Morningstar Midcap Value (JKI) and Rydex S&P MidCap 400 Pure Value (RFV).

RydexShares has something going with the S&P Pure indexes, as both the value and the growth performed well. The value ETF, RFV, held 24 percent of assets in financials, one of the better-rebounding sectors. RFG benefited from exposure to the materials sector and retailers such as top-ten holdings J. Crew (JCG) and Aeropostale (ARO), the latter of which is on the verge of a new 52- week high.

The difference between asset classes was smaller, with PowerShares Dynamic Mid Cap Growth (PWJ) up 7.50 percent in the past three months, versus a 36.92 Compared to EMG, RFG does not appear to be all that different. EMG has about 5 percent more of its assets in technology, media and telecom, while RFG has more spread across the other sectors. EMG has a more diversified portfolio, with the top holding barely registering 1 percent of assets. RFG packs about 20 percent into the top ten. EMG saves you 0.1 percent on expenses, but this will be subsumed by performance even in the short run.

The blended mid-caps that outperformed last month were VXF and RWK. VXF is a mid-cap with a median market cap of $1.6 billion, but its top holding is $50 billion Visa (V).

RWK tracks the S&P MidCap 400 Index, which is a favorite in this space and, therefore, has holdings similar to those of the other funds mentioned. However, like RFG, its revenue-based weighting leads to higher allocations among the top ten, also about 20 percent of assets at the end of July. Meanwhile, VXF, in typical Vanguard style, has 3,013 holdings.

Mid-cap value produced two of the top three performers, and the number one by a long shot. RFV has a large allocation to materials and finance, in addition to being heavily overweight in its top holdings. Oshkosh Truck (OSK), Temple-Inland (TIN) and Ashland (ASH) rebounded more than 600 percent off their lows, lifting their allocations in the fund to more than 6 or 7 percent. In sum, the top 10 account for more than 38 percent of assets.

JKI outperformed due to a 30 percent allocation in financials, followed by materials and consumer goods, and has 188 holdings, with SunTrust Banks (STI) in the top spot, at 1.38 percent of assets.

Investors looking for solid mid-cap exposure with minimal investigation should stick to the broader funds with lower expense ratios. RydexShares offers a unique approach worth considering, although RFV’s top- heavy portfolio will create volatility. In the last three months of 2008, it was the worst-performing mid-cap in the newsletter, underperforming by an amount similar to its outperformance since the end of April.

Source: Are Mid-Caps Ready to Lead the Rally?