Seeking Alpha
, Joe Springer (445 clicks)
Long/short equity
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Summary

  • Large-cap index funds are extremely popular.
  • Mid-cap index funds swap holdings with large cap funds.
  • As long as large-cap index funds enjoy their popularity, mid-cap index funds will enjoy an advantage.

Want to beat most fund managers as a passive investor? Buy and hold the Vanguard Mid-Cap ETF (NYSEARCA:VO).

We recently wrote on why VO is a great index fund for passive investors. Here is another reason: current large-cap index fund popularity means that mid-cap index funds re-balance advantageously.

Mid-cap index funds like VO are not nearly as popular as large-cap index funds like the S&P 500 fund (NYSEARCA:SPY).

When these mid and large-cap funds rebalance, the stocks that they hold move from one index fund to the other (not on an immediate one-for-one basis, but the dynamics of supply and demand are there).

Currently the SPY has dozens of constituents with market caps in the single digit billions, going as low as $4 billion. VO's largest holdings currently extend into the double digit billions, going as high as $24 billion.

On rebalancing, all things being equal, the selling of VO's large stocks would be offset by the buying of those stocks in SPY. Likewise, the selling of SPY's small stocks would be offset by the buying of those stocks in VO.

But all things are not equal.

Large-cap index funds are in 401(k)s and IRAs as a default of sorts. Poll the average investor on Main Street and there is little chance they own a mid-cap fund, but the odds are good they are in a large-cap fund. And big money goes to large-cap funds - the biggest and richest entities need large capitalization in equities for the relative liquidity.

So when all the mammoth large-cap funds are buying the latest stocks that cross the threshold into "largeness," the mid-cap funds are selling out of these stocks. And when all the mammoth large-cap funds are selling out of fallen large-cap stocks, the mid-cap funds are buying these stocks.

So as long as the large-cap index funds are so much more popular than the mid-cap index funds, the mid-caps are buying when there is a lot of supply, a buyers' market. And they are selling when there is a lot of demand, a sellers' market. And it's structural, so it requires no active management, and allows VO to have that low expense ratio of .09%.

This advantageous dynamic is likely one of the reasons VO has beaten the SPY handily since inception:

(click to enlarge)

Bottom Line

There seems to be no let up in the trend of large-cap index fund popularity, and mid-cap funds like VO should continue to enjoy a structural advantage over (and because of) large-cap funds like SPY.

Source: Beat Most Fund Managers In One Step