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Do you need a mid-cap fund?

Mid-caps offer great risk/reward potential, but check your existing weightings before buying a dedicated fund.

Karen Wallace 14 September, 2015 | 5:00PM
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Question: Do I need a mid-cap fund in my portfolio? If so, what percentage of my assets should it be?

Answer: It's not hard to understand the rationale for adding small-cap stocks to a portfolio. In contrast to their larger-cap, more-mature peers, small-cap companies are often more nimble and have greater growth opportunities ahead of them, which can equate to higher long-term returns. But what about companies that fall into the mid-cap squares of the Morningstar Style Box? Do you need to bother with mid-caps at all?

Sometimes referred to as the market's sweet spot, mid-cap stocks are positioned in a way that gives them the potential to achieve impressive risk-adjusted returns. Mid-cap companies are usually not as dependent on a single product as their smaller-cap peers can be, meaning that mid-caps' revenue and cash flow are often more consistent and the stock price is less volatile. But mid-caps are also not yet hampered by their size, either (meaning that once a company reaches the mature large- or giant-cap stage, its growth potential slows down).

And if you look at the data below, you can see that domestic equity funds that fall in the mid-caps sections of the Morningstar Style Box have outperformed their large-cap peers, but with lower volatility than small caps. In fact, the returns of mid-cap stocks have also beaten those of small-cap stocks during the trailing three- and five-year periods, with lower volatility (as measured by standard deviation).

Average returns, standard deviation of Canadian domestic equity funds
3-yr
return
3-yr
std dev
5-yr
return
5-yr
std dev
10-yr
return
10-yr
std dev
Cdn sm cap funds (avg) 12.2 11.2 10.0 14.1 6.9 17.8
Cdn mid-cap funds (avg) 12.5 8.4 10.1 10.2 5.9 14.1
Cdn lg cap funds (avg) 11.5 7.0 8.6 9.2 5.5 13.1
Data through June 30, 2015.
Source: Morningstar PALTrak

Morningstar defines large caps as the top 70% of companies trading in their respective market by market capitalization (in Canada, this means companies with a market cap above roughly $9.5 billion, while for U.S. stocks the threshold is about US$16 billion, as of Aug. 31). Mid-caps are the next 20% by market cap (which encompasses Canadian companies above $1.5 billion but below $9.5 billion and U.S. companies above US$3.6 billion but below US$16 billion). Small caps, as defined by Morningstar, are the smallest 10% of the market, or Canadian companies with market caps below $1.5 billion and U.S. companies below US$3.6 billion.

Of course, past is not prologue--meaning that there is no guarantee that mid-caps will continue to outperform small caps during the next 10-year period; in fact, small caps probably have more long-term upside potential than mid-caps, especially at mid-caps' current valuations.

How much exposure to mid-caps do you need?

To determine how much exposure an investor needs to mid-caps, the total stock market can be a good starting benchmark. As you would expect based on the definition, broad market index funds typically devote about 20% to mid-caps--6% to 7% in each of the mid-cap style box squares. Morningstar data show mid-caps as accounting for 20% of its U.S. equity universe.

The mid-cap weightings of many balanced or portfolio funds land in a similar ballpark. The 100 largest balanced funds in Canada hold on average 22% of their equity stake in mid-cap stocks, though the weights of individual funds vary quite a bit.

What do you already own?

If you have a portfolio saved in Morningstar.ca's Portfolio Manager tool, it's easy to see how much exposure to small- and mid-caps you already have. It's possible that you don't need to own a pure mid-cap fund if you already have plenty of exposure to smaller-cap companies in your portfolio. ( Portfolio X-Ray can show you the percentage of your equity exposure that falls into each square of the style box, which helps you get a handle on how much of your portfolio's equity exposure is in mid-caps versus small caps and large caps.) For instance, as I mentioned earlier, about 20% of broad market indexes are currently in mid-caps. So, if you have a total market index fund, you may have all you need unless you wanted to explicitly overweight this pocket of the market.

Choosing the best fund for your portfolio

If, after examining your holdings, you decide that your portfolio would benefit from adding a mid-cap fund, there are some different routes you could take.

There are very few mutual funds in Canada that specifically target the mid-cap segment; a perusal of Morningstar's database reveals only two Canadian equity funds, two global equity funds and four U.S. equity funds that invest in mid-cap stocks as per their stated objectives. The largest and oldest of these are Mackenzie U.S. Mid Cap Growth, Investors European Mid Cap Equity and TD U.S. Mid Cap Growth, all of which are rated 4-stars in their respective categories.

Alternatively, investors might consider a fund that invests in both small- and mid-cap stocks in one fell swoop (sometimes you hear this referred to as a "smid" allocation). These funds land in one of four standard categories in Canada: Canadian Small/Mid Cap Equity, Canadian Focused Small/Mid Cap Equity, U.S. Small/Mid Cap Equity and Global Small/Mid Cap Equity. These categories contain a plethora of choices, including several that are very highly rated by Morningstar analysts. It's worth noting that even funds that are marketed as "small cap" will typically contain a generous helping of mid-cap stocks.

A smid or blended small/mid-cap allocation can make sense because it can lead to higher returns than a purely large-cap-focused equity exposure over long periods, but adding in the mid-caps helps tamp down some of the volatility you would experience if you offset your large caps with only small- and micro-cap stocks. Smid funds allow you to have just one fund instead of two smaller positions. Smid funds may also be better than dedicated small- and mid-cap funds from a tax-efficiency perspective, because their market-cap parameters are more fluid. A few of Morningstar's favorite smid funds include Mawer Global Small Cap and Beutel Goodman Small Cap.

As for ETF options, BlackRock last month launched iShares S&P U.S. Mid-Cap Index ETF (XMC) as well as a currency-hedged version of the same fund (XMH). For investors who wish to target the Canadian mid-cap segment,  iShares S&P/TSX Completion (XMD) offers the closest alternative to a pure play with about 65% of its portfolio allocated to mid-cap stocks.

Have a personal finance question you'd like answered? Send it to AskTheExpert@morningstar.com.

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About Author

Karen Wallace

Karen Wallace  Karen Wallace, CFP® is Morningstar’s director of investor education.

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