By Stoyan Bojinov
Ongoing worries of a global economic slowdown coupled with Euro zone debt woes have prompted many investors to reallocate capital to safer corners of the market in recent months. U.S. large cap stocks have been a popular destination, largely considered a “safe haven” amongst equity investors, as this asset class has staged an impressive comeback since earlier in October of this year. However, investors looking to further diversify the equity portion of their portfolio ought to take a closer look at mid cap U.S. equities. Mid caps are often overlooked, although research suggest that this asset class can offer an appealing risk/reward profile relative to large cap stocks.
Investing in mid cap equities may be appealing to investors who are seeking out the potential for significant capital appreciation while still maintaining relatively “safe” exposure, unlike small and micro cap stocks which are know to be more volatile. Mid caps have also been known to outperform their large cap counterparts; in 2010, the SPDR S&P MidCap 400 ETF (MDY) gained a whopping 26%, while the more popular SPDR S&P 500 ETF (SPY) lagged behind, returning only 15% during the same time period.
Innovation in the ETF industry has brought forth a number of products for investors looking to gain access to the mid cap corner of the equity market. Although the most popular products on the market are linked to market capitalization-weighted benchmarks, investors looking to diversify away from this traditional methodology have a whole host of options. One potential flaw of this popular approach is that because cap-weighted indexes determine the allocation given to each security based on the company’s market capitalization–and therefore the price of the stock–there is a tendency to overweight overvalued companies and underweight undervalued stocks. The cap-weighted approach may potentially have a significant impact on bottom-line returns when investors consider that leading up to this most recent financial crisis as well as the years prior to the tech-bubble, cap-weighted indexes were overweighting the financial and tech sectors respectively.
Below we highlight several interesting mid-cap ETFs that employ alternative methodologies as well as comparing their year-to-date performance:
First Trust Mid Cap Core AlphaDEX (FNX)
|All returns as of 11/11/2011|
The index underlying FNX is an “enhanced” index that employs the proprietary AlphaDEX methodology to select stocks from the S&P MidCap 400 Index. This ETF uses several fundamental factors to assign weights to its component securities as potential holdings are ranked on a variety of quantitative metric that contribute to an overall score. The bottom-ranking 25% are then eliminated and the top 75% is then separated into quintiles. Stocks are equally weighted within the quintiles, and the most promising quintiles receive the greatest weighting. In essence, the least promising mid cap stocks from the investable universe are either omitted altogether or given minimal weightings. The AlphaDEX methodology has proven its potential to outperform traditional cap-weighted indexes, seeing as how FNX leads the group higher in terms of year-to-date performances with a robust 2.3% gain.
RevenueShares Mid Cap Fund (RWK)
RWK tracks an index that includes the stocks of the S&P MidCap 400 Index, except unlike MDY which is cap-weighted, this ETF determines the allocation given to each security based on top line revenue over the previous 12 months. By utilizing this alternative weighting methodology, RWK tends to overweight companies with low price-to-sales ratios and underweight those with high price-to-sales ratios. This strategy is somewhat of a value investing approach as it focuses on tilting exposure towards undervalued companies based on revenues, while avoiding hefty allocations to pricier stocks with relatively lower revenues. RWK is in slight red territory for the year, clinching a small loss of about 1%.
Rydex Russell Mid Cap Equal Weight ETF (EWRM)
This ETF employs an alternative weighting methodology and selects its holdings from the Russell Midcap Index. EWRM holds each component of the Russell Midcap Index in equal proportions, resulting in a truly well-balanced portfolio. The fund invests in almost 800 securities in total and no single holding accounts for over 0.5% of total assets. Relative to IWR, which tracks the cap-weighted version of the same index, EWRM is more heavily tilted towards industrial and technology holdings, while the latter features a far greater allocation to financial services. EWRM is trailing only FNX in terms of year-to-date performances, returning a solid 1.2%, while the majority of the other mid cap funds are lagging behind in negative territory.
PowerShares RAFI Fundamental Pure Mid Cap Core Portfolio (PXMC)
The idea behind the RAFI weighting methodology is relatively straightforward, and the actual process of determining holdings is simple as well. Whereas cap-weighted indexes generally determine components and individual allocations based on market capitalization, the RAFI approach employed by PXMC considers multiple fundamental factors to determine a stock’s weight in the index, including cash flow, book value, sales and dividends. PXMC selects its holdings from a universe comprised of 2,500 mid cap U.S. stocks, and its underlying portfolio consists of about 150 securities, with no single holding accounting for more than 2% of total assets.
RBS U.S. Mid Cap Trendpilot ETN (TRNM)
This one of a kind ETN is linked to the RBS U.S. Mid Cap Trendpilot Index, a dynamic benchmark that shifts exposure between mid cap stocks and low risk Treasuries depending on observable price signals. When the S&P MidCap 400 Index is at or above its 200-day simple moving average, TRNM will be invested in mid cap stocks. However, if the S&P MidCap 400 closes below its 200-day moving average for five consecutive sessions, exposure will be shifted into 3-month U.S. Treasury bills. TRNM has been out of the market and invested in Treasuries since August given the fact that mid cap stocks still appear to be in a downtrend from a technical analysis perspective.
Disclosure: No positions at time of writing.
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