Are There Large-Cap Stocks Lurking In Your Mid-Cap ETF?

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Includes: EQWM, IJH, ITOT, IWR, SCHB, SCHM, VO, VTI, VXF
by: Bottom Fisher Ideas

Summary

There is no set definition of what constitutes a mid-cap stock.

Some mid-cap ETFs are dominated by S&P 500 constituents.

Mixing and matching indexes comes with risks and inefficiencies, but there are good options available.

Investment Thesis

Mid-cap stocks are a valuable addition to any portfolio, but can be confusing. Mid-cap definitions and ETFs vary widely from firm to firm. Take a close look at the index that your mid-cap ETF is tracking to determine if its the right fit for you.

Overview

Despite their history of great performance, mid-cap stocks are often overlooked by investors. Its no wonder, as investment professionals can't even agree on what constitutes a mid-cap stock. If you ask them, you'll get a wide variety of answers.

  • NASDAQ says that a mid-cap stock is between $1 billion and $5 billion in market capitalization.
  • Standard & Poors requires candidates for inclusion in their S&P MidCap 400 index to have market caps between $1.4 billion and $5.9 billion, although over the course of stock advances and declines during the year, the actual range ends up being closer to $1 billion to $10 billion.
  • TIAA-CREF has a broader definition, calling anything between $1 billion and $15 billion a mid-cap stock.
  • Wilshire defines a mid-cap stock as those companies that are ranked between 501st and 1000th by market cap in their Wilshire 5000 Index. This ends up being in the $2 billion to $10 billion range.
  • MSCI classifies mid-cap stocks as the 301st to the 750th largest US firms. This results in market caps from $2.5 billion to $25 billion.
  • CSRP defines mid-caps as anything falling between the top 70%-85% of investable market capitalization. This provides a range between $1 billion and $30 billion.
  • Russell classifies a mid cap stock in the US as the bottom 800 of the Russell 1000, basically the 201st to the 1000th largest firms by market cap. This leads to a range of between $2 billion and $30 billion.

Confused? You aren't alone. While it makes it difficult to talk or write about a stock on the periphery of these ranges, it can also have an impact on your investing.

Vanguard Mid-Cap ETF

Consider the Vanguard Mid-Cap ETF (VO), which tracks the CSRP US Mid Cap Index. It contains 348 stocks and it is market cap weighted. These are its top ten holdings as of 5/31/17:

  1. Electronic Arts Inc. (NASDAQ:EA)
  2. Equinix Inc. (NASDAQ:EQIX)
  3. Fiserv Inc. (NASDAQ:FISV)
  4. Western Digital Corp. (NASDAQ:WDC)
  5. Newell Brands Inc. (NYSE:NWL)
  6. Lam Research Corp. (NASDAQ:LRCX)
  7. Edwards Lifesciences Corp. (NYSE:EW)
  8. Autodesk Inc. (NASDAQ:ADSK)
  9. Roper Technologies Inc. (NYSE:ROP)
  10. Amphenol Corp (NYSE:APH)

Source: Vanguard

According to the latest data from Seeking Alpha, these companies have market caps ranging from $22 billion to $33 billion, well above what what most consider to be mid-cap companies. All ten companies, along with numerous other holdings, are members of the S&P 500 Index. And because the index is market cap weighted, the movements of the $30 billion holdings have a much larger effect on the ETF than movements of the $2 billion holdings.

If you bought the Vanguard Mid-Cap ETF to supplement an S&P 500 Index fund, to diversify and add mid-cap exposure, you'll find yourself with significant overlap in holdings and higher correlation than you might have bargained for.

iShares Russell Mid-Cap ETF

That isn't the only ETF with this problem. The iShares Russell Mid-Cap ETF (IWR) tracks the Russell Mid Cap Index and has a similar profile. It contains 791 holdings and its top ten holdings as of 6/29/17 are:

  1. Prologis (NYSE:PLD)
  2. Zoetis (NYSE:ZTS)
  3. Sempra Energy (NYSE:SRE)
  4. Analog Devices Inc. (NASDAQ:ADI)
  5. Fidelity National Information Services Inc. (NYSE:FIS)
  6. SunTrust Banks Inc. (NYSE:STI)
  7. Welltower Inc. (NYSE:HCN)
  8. Western Digital Corp. (NASDAQ:WDC)
  9. Marathon Petroleum Corp. (NYSE:MPC)
  10. PPL Corp. (NYSE:PPL)

Source: iShares

These ten holdings range in market cap from $26 billion to $31 billion and are all members of the S&P 500. Since this fund has over twice as many holdings as the Vanguard Mid-Cap ETF, the biggest holdings have slightly less of an impact. But since there are many holdings beyond the top ten that are also members of the S&P 500 and because the ETF is market cap weighted, what some consider large-cap stocks still have an out-sized influence on the performance of the ETF.

Alternatives

If you invest in funds that track the CSRP large cap index and small cap index, then the Vanguard Mid-Cap ETF will be a perfect fit for your portfolio. Similarly, if you invest in other Russell index products, then iShares Russell Mid-Cap ETF might be just what you need to get your mid-cap exposure.

The problem arises if you are investing in an S&P 500 or other large cap index product, and you aren't aware that there may be significant overlap with your mid-cap index fund.

Here are some options for getting mid-cap exposure if you aren't strictly following a diet of CSRP or Russell index products:

S&P Mid-Cap or Dow Jones Mid-Cap Index ETFs

The iShares Core S&P Mid-Cap ETF (IJH) and the Schwab US Mid-Cap ETF (SCHM) follow the S&P 400 MidCap and the Dow Jones US Mid-Cap Total Stock Market Index, respectively. The both include companies with market caps in the range of $1 billion to $10 billion, which more closely aligns with widely held definitions of mid-cap stocks. If you hold an S&P 500 index fund as your large cap holding, these two ETFs provide a more appropriate means of getting mid-cap exposure.

Extended Market ETFs

If your only index fund is tracking the S&P 500, then there are ETFs that are designed specifically to give you both mid-cap and small-cap exposure. The Vanguard Extended Market Index Fund (VXF) is a good option if you hold the S&P 500 and find that you want to add mid-cap and small-cap stocks.

Total Stock Market ETFs

Instead of buying one product for large cap exposure, a second product for mid cap exposure, and a third product for small cap exposure, there are ETFs that represent the entire stock market. Whether its the iShares Core S&P Total U.S. Stock Market ETF (ITOT), the Schwab U.S. Broad Market ETF (SCHB), or the Vanguard Total Stock Market Index Fund (VTI), these ETFs offer one stop shopping that encompasses large-cap, mid-cap, and small-cap stocks.

Equal Weight ETFs

While equal weight ETFs don't eliminate the issue of overlap, they do eliminate the problem of $30 billion companies having an undo influence on the ETF. If you are determined to mix an S&P 500 Index ETF with a Russell Mid-Cap Index ETF, then the Powershares Russell Midcap Equal Weight Portfolio (EQWM) could be the best choice. While expenses on equal weight ETFs tend to run higher than market weight ETFs, there is research that indicates that equal weight funds outperform.

Conclusion

Not all mid-cap ETFs are created equal. Many are designed specifically for pairing with large-cap and small-cap ETFs from the same index family, and don't mesh well with other ETFs. There are many options for making sure that you have mid-cap exposure, just make sure you take a close look at the ETF and its holdings to see if its right for you.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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