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By Jeremy Schwartz

I recently had a conversation with Craig Lazzara, Head of Index Investment Strategy at S&P Dow Jones Indices, about his research on dispersion-a factor he believes is very important in explaining the opportunities for active managers. According to Craig, current dispersion readings are quite low, which implies there are fewer opportunities for active managers than usual.

Craig finds there is greater dispersion in mid-cap stocks than large-cap stocks, so the question is: Does this lead to more outperformance for active managers-or just more dispersion between the best and worst managers in the mid-cap category?

As a follow-up to that discussion, I thought it would be interesting to see how active managers had performed against broad indexes over the past decade. I recently looked at small-cap equities, which you can read here, but now I'd like to expand the analysis to mid-cap equities.

There Are Many Ways to Invest

There are numerous ways to invest, but the decision usually starts with whether to invest in either active mutual funds or passive exchange-traded funds (ETFs). Some argue that active managers are best suited to outperform, especially in mid-capitalization stocks, because they think this area tends to be less efficient. Recently, as a result of the broad market rally, these same proponents of active managers have insisted that today's environment is ripe for active managers to outperform, so I want to take a hard look at the numbers.

In the table below, I compare how some mid-cap indexes have performed against U.S. ETFs and open-end mutual funds in Morningstar's Mid-Cap Blend category.

Mid-Cap Study (12/31/03-12/31/13)

(click to enlarge)

The Majority of Active Managers Underperform - Over the most recent 10-year period the Russell Midcap Index and the S&P MidCap 400 Index outperformed 81.7% and 87.4%, respectively, of funds in the Morningstar Mid-Cap Blend category. The Russell Midcap also outperformed more than 50% of the Morningstar category in 9 out of the past 10 calendar years, and the S&P MidCap 400 outperformed more than 50% of the category in 7 out of the past 10 calendar years.

The WisdomTree MidCap Earnings Index - WTMEI has outperformed close to 99% of the Morningstar category since its inception. I find it impressive that the Index was able to outperform over 75% of the category during the worst calendar year for the category (2008) as well as during the best one (2009).

Why Indexes?

Like all investors, active managers are susceptible to behavioral biases that can negatively affect their investment decisions. This is illustrated through the table above, which shows that the majority of active managers actually underperformed their respective benchmarks over the most recent 10-year period and over the majority of calendar years.

For believers of active management, I think these results are even more alarming given the fact that the Russell and S&P indexes are market cap-weighted. Market cap-weighted indexes typically give the greatest weight to the stocks with the highest prices, without regard to any measure of fundamental value. As a result, the market capitalization-weighted index may tend to over-weight more expensive equities and under-weight those that may be relatively less expensive.

Why Smart Beta?

Although I do not feel active management is necessary to provide compelling long-term returns, I do think it is important to invest with a disciplined focus on valuations. WisdomTree uses a rules-based methodology to weight the companies in its Indexes by their underlying fundamentals, such as dividends or earnings, because at WisdomTree we believe that stock markets are not always efficient. Furthermore, WisdomTree rebalances its Indexes annually to adjust for relative value.

As I referenced above, although dispersion levels can't predict active manager performance, the current low dispersion levels imply that there are potentially fewer opportunities for active managers than usual. Given this reading and the historical underperformance of active managers against traditional indexes, I do not think it is time for active management in mid-cap equities.

Sources: Zephyr StyleADVISOR, Morningstar; Index inception: 02/01/2007.

Important Risks Related to this Article

There are risks associated with investing, including possible loss of principal. Funds focusing their investments on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Please read the Fund's prospectus for specific details regarding the Fund's risk profile.

This material contains the current research and opinions of the author, which are subject to change, and should not to be considered or interpreted as a recommendation to participate in any particular trading strategy or deemed to be an offer or sale of any investment product, and it should not be relied on as such. The user of this information assumes the entire risk of any use made of the information provided herein. Unless expressly stated otherwise, the opinions, interpretations or findings expressed herein do not necessarily represent the views of WisdomTree or any of its affiliates.

Jeremy Schwartz, Director of Research

As WisdomTree's Director of Research, Jeremy Schwartz offers timely ideas and timeless wisdom on a bi-monthly basis. Prior to joining WisdomTree, Jeremy was Professor Jeremy Siegel's head research assistant and helped with the research and writing of Stocks for the Long Run and The Future for Investors. He is also the co-author of the Financial Analysts Journal paper "What Happened to the Original Stocks in the S&P 500?" and the Wall Street Journal article "The Great American Bond Bubble."

Source: The Active Vs. Passive Debate In Mid-Cap Equities