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When only the biggest stocks will do

Mega-cap stocks may be slow-growing, but their low volatility has appeal.

Michael Rawson, CFA 25 August, 2015 | 5:00PM
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Guggenheim Russell Top 50 Mega Cap ETF (XLG) invests in the biggest of the big. In fact, its US$209 billion average market cap is higher than any other mutual fund or exchange-traded fund in the United States and Canada, and nearly three times that of the S&P 500 Index. Mega-cap stocks have different risk and return characteristics than mid- and small-cap stocks, and those looking to target these stocks might consider XLG. The fund provides low-cost, market-cap-weighted exposure to 50 of the largest U.S. companies.

Mega-cap stocks tend to be mature industry leaders or globally diversified conglomerates with sustainable competitive advantages and international reach. While mega-cap stocks individually may have lower risk than small caps, they may also have lower growth potential.

This ETF is a suitable core holding for the U.S. equity portion of a portfolio, but there are better-diversified and lower-cost alternatives for those looking for complete exposure to the U.S.-equity market. It tracks the Russell Top 50 Mega Cap Index, which covers roughly the largest 50 U.S. stocks in the Russell 1000, so it lacks small-, mid- and even many large-cap stocks. In aggregate, it covers less than half of the U.S.-equity market. In contrast, the Russell 3000 Index covers more than 98% of the total stock market. Although including smaller-cap stocks increases volatility, the broader Russell 3000 Index has generated a higher return since the 2001 inception of the Russell Top 50 Mega Cap even after adjusting for its higher risk, as a result of the strong performance of small-cap stocks.

Holding a broad fund rather than separate size-segment funds can lead to lower turnover. However, this fund can be effective in a lineup of size-segment funds for investors who prefer tight control over their market-cap allocations or who wish to give a tactical overweighting to mega-cap stocks. For those investors who prefer to hold separate size-segment funds, this ETF doesn't pair up well with other popular index funds, as it overlaps with the Russell 1000 but would leave out stocks when paired with the Russell Mid Cap Index. And it won't offer much diversification potential to the S&P 500. The Russell Top 50 Mega Cap Index was nearly perfectly correlated with the S&P 500 over the past 14 years.

Fundamental view

U.S. mega-cap stocks posted dominant returns in the 1990s. By the end of that decade, they traded at a large premium to small-cap stocks. That situation has now reversed as the return of the mega-cap-oriented Russell Top 50 Mega Cap Index has lagged the return of the Russell 2000 Index of small-cap stocks by 3.3 percentage points per year between 2001 through July 2015. Stocks in the Russell Top 50 Mega Cap Index now trade at a price/forward earnings ratio of 18 times compared with 21 for the Russell 2000 Index. This could be justified by mega-cap stocks' lower growth potential.

Analysts forecast 9% earnings growth for stocks in the Russell Top 50 Mega Cap Index compared with 12% growth for stocks in the Russell 2000 Index, according to consensus estimates presented in Morningstar Direct. Slower-growth companies typically have fewer capital investment opportunities and, thus, often have higher dividend payout ratios. The dividend yield for the Russell Top 50 Mega Cap Index of 2.3% is almost a percentage point higher than the average yield on stocks in the Russell 2000 Index.

While mega-cap stocks may have slower growth, they are also less volatile. The standard deviation of return of the Russell Top 50 Mega Cap Index has been 13.8% during the past 10 years compared with 19.5% for the small-cap stocks in the Russell 2000 Index. This may be because mega-cap companies tend to be better diversified and are more likely to enjoy sustainable competitive advantages than smaller companies. The fund has 72% of its assets invested in stocks with Morningstar Economic Moat Ratings of Wide, Morningstar's assessment that a firm enjoys a sustainable competitive advantage. That compares with just 49% of assets for the S&P 500. Its holdings also tend to be more profitable. They generated a higher average return on invested capital in the trailing 12 months through July 2015 (15.1%) than the average constituent in the S&P 500 (13.7%).

Based on Morningstar equity analysts' fair value assessments of the fund's underlying holdings, it is trading at a price/fair value ratio of about 0.94, slightly lower than the corresponding figures for the S&P 500 (0.96) and total U.S. equity market (0.97).

Fees

XLG's 0.20% expense ratio is low in absolute terms, but broader funds that include more large- and mid-cap stocks are available for less. The fund has lagged its index by more than its expense ratio from time to time, but over the past year, it has done a good job tracking its index.

Alternatives

 Vanguard Mega Cap ETF (MGC) charges a lower fee (0.11%) but provides less-targeted coverage of mega-caps because it includes more large caps. It targets the largest companies that constitute 70% of the market, compared with about 38% for XLG. Whereas stocks in XLG have an average market capitalization of US$209 billion, for MGC that number is US$94 billion.  iShares S&P 100 (OEF) (0.20% expense ratio) tracks 100 of the largest stocks with a liquid options market. The average market cap for that fund is US$153 billion. For Canadian investors who prefer a domestically listed ETF, BMO Dow Jones Industrial Average (Hedged to C$) ETF (ZDJ) (0.26% expense ratio) invests in a compact list of 30 blue-chip stocks. While the index MGC follows is mechanically constructed and market-cap-weighted, stocks in ZDJ are handpicked for industry leadership and weighted by price. ZDJ has an average market cap of US$139 billion (C$173.1 billion).

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About Author

Michael Rawson, CFA

Michael Rawson, CFA  Michael Rawson, CFA, is an analyst covering equity strategies on Morningstar’s manager research team.

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