As investment consultants, one of our critical responsibilities is helping clients construct their investment lineup. The first step in this process is to decide which asset classes should be represented in that lineup. One of the biggest questions that we address is whether it is appropriate to include mid cap stock funds within the investment lineup. While mid cap funds are becoming increasingly popular, I would argue that they are not necessary, and in some cases may be detrimental, within a defined contribution plan’s investment lineup.
What Are Mid Cap Stocks?
I think it helps to first define what is a mid cap stock. Unfortunately, there is not a standard definition of what constitutes a mid cap stock. Multiple index families have created mid cap stock indices that each define mid cap as an "asset class" in different ways. The table below shows a quick comparison of two of the most popular mid cap indices: the Russell Midcap Index and the S&P MidCap 400 Index.
In looking at the two mid cap indices, I focus on the Russell MidCap Index definition, because we primarily use Russell indices in our domestic equity analysis and we have found that Russell indices are the most commonly used by active managers to benchmark their portfolios. In addition to the fact that Russell’s definition focuses on larger companies than S&P’s index, what stands out the most is the fact that the Russell MidCap Index is a subset of another Russell index rather than being mutually exclusive with the Russell 1000 Index, Russell’s large cap benchmark. Russell does offer a Russell Top 200 Index that is mutually exclusive with the Russell MidCap Index but is not used frequently as a benchmark for large cap managers. In fact, a review of Morningstar’s mutual fund database shows that only 2 actively managed mutual funds use the Russell Top 200 Index, or one of its style variants, as the primary benchmark in their prospectus.
When evaluating assets classes there are two primary reasons to include an asset class in a portfolio: 1) it provides a performance premium to the existing assets in the portfolio or, 2) it provides a diversification benefit to the existing portfolio. In evaluating mid cap stocks, let’s first look at whether there is a return premium for them. I have seen on multiple occasions where someone has identified mid cap stocks as the "sweet spot" of the market, outperforming both large cap stocks and small cap stocks.
The table below shows the annualized performance from January 1926 through December 2009 for the Center for Research in Security Prices (CRSP) deciles. These deciles are based on market capitalization with the Decile 1 being the largest stocks and Decile 10 being the smallest stocks. As the table shows, there is no evidence in the long-term history that mid cap stocks outperform both large and small cap stocks. Instead, what is demonstrated is that there is a small cap premium. This small cap premium has been identified for almost 30 years in academic research and is quite consistent with the common sense notion that risk and return are related; small cap stocks are riskier than large cap stocks, so they have a return premium over large cap stocks. The small cap premium has also been found to exist in multiple international equity markets.
Most people that point to mid cap stocks being the "sweet spot" in the U.S. market point to performance of the Russell MidCap Index relative to the Russell 1000 and Russell 2000 since those indices were developed. The table below shows the Russell indices as well as the CRSP deciles since Russell developed their indices.
At first blush, the Russell indices show a significant mid cap return premium over large cap and small cap stocks. This might seem compelling but the CRSP data muddies the picture. While there is a premium for all of the deciles over the CRSP Decile 1 Index, it is not as clear that there is a premium for mid cap stocks over small cap stocks. Instead, most of Deciles 1-9 fall within a very close performance range.
Given the mixed messages, who are we to trust more? I tend to favor the CRSP data set because it is more inclusive of a broader set of securities. Additionally, and I think even more importantly, the Russell 2000 Index has experienced a well-documented "reconstitution effect" that has created drag on the Index’s returns. The reconstitution effect is the result of managers front-running the index prior to the day each year when Russell updates the indexes. Active managers can buy stocks that are likely to enter into the index and sell stocks that are likely to fall out of the index prior to when Russell reconstitutes the index. Knowing that stocks within the universe have greater demand, active managers can get in early to capture a return premium over the benchmark. This drag on the Russell 2000 Index performance might be one of the primary contributing factors in why the Russell MidCap Index outperformed the Russell 2000 Index so significantly during this time period.
Regardless of whether you are looking at CRSP data, Russell data, the 1926-2009 time period, or the 1979-2009 time period, it is important that there be a rational basis for what is observed in the data. If there is not a rational basis for a return premium to exist, it is quite possible that it is the result of data mining, either intentionally or accidentally, and it will not necessarily replicate itself in the future. With that in mind, the most fundamental truth of investing is "Risk and return are related." There is nothing that points to mid cap stocks being riskier than small cap stocks and therefore deserving of a return premium over small cap stocks.
Correlation to Other U.S. Equities
The second possible reason for including an asset class in a portfolio is because it provides a diversification benefit. The basic idea is that assets that behave differently have the ability to offset each others’ extreme moments, thereby smoothing out the returns for the total portfolio. This is the basis for Modern Portfolio Theory (MPT) and the idea of the efficient frontier. Theoretically, combining a diverse set of assets will make a portfolio more efficient, enabling an investor to reduce risk and maintain the same expected return or enabling an investor to increase their expected return while maintaining the same risk level.
To measure an asset’s ability to diversify a portfolio, we usually look at its correlation to the total portfolio or to other asset classes within the portfolio. Correlation is a measure of the relationship between two items. Possible values range from +1 to -1, with a +1 indicating a perfectly positive correlation, and a -1 indicating a perfectly negative correlation. When comparing asset classes, a +1 would indicate that whenever one asset class had a gain, the other asset class also had a gain. A -1 would indicate that whenever one asset class had a gain, the other asset class would have a loss. For investors, negative correlations are ideal, albeit very rare, because they provide the most diversification benefit.
The table below shows the historical correlations of the nine Russell indices that divide the U.S. equity market up by market capitalization and investment style. Highlighted are the correlation values of each mid cap index to their corresponding style large and small cap indices (i.e. MidCap Value to 1000 Value and 2000 Value). As the table shows, the mid cap indexes consistently have a correlation in excess of 0.90 to their counterpart style indexes. This indicates a very high correlation between the two indexes as well as very little diversification benefit by holding both asset classes within a portfolio.
Correlation of Russell Indices (Jan. 1986 – Dec. 2009)
Investment Style of Active Managers
Up to this point we have mainly discussed the potential benefits of including mid cap stocks within a portfolio. While that discussion is somewhat relevant, it is important to evaluate the portfolios of the investment managers that will actually be utilized to determine how they invest.
In the table below I analyzed the Morningstar US Mutual Fund database to determine the average style for mutual funds in each of Morningstar’s 9 "style boxes" for U.S. equity funds. I limited the search to distinct funds (no multiple share classes) with a minimum of a 5 year track record. To determine investment style I used a returns-based style analysis with seven indices as the independent variables in my model: 3-month T-Bills, Russell Top 200 Value, Russell Top 200 Growth, Russell MidCap Value, Russell MidCap Growth, Russell 2000 Value, and the Russell 2000 Growth Index.
Returns-Based Style Analysis of Mutual Funds (5 Yrs Ending 5/31/2010)
A couple things stand out in this analysis. First, most large cap managers have a pretty significant weight to mid cap stocks. On average, large value managers have 26.76% exposure to mid cap stocks, large blend managers have 29.24%, and large growth managers have 37.21% exposure. This is consistent with the fact that the Russell MidCap Index is roughly 31% of the Russell 1000 Index by market capitalization.
The second thing to stand out is the amount of mid cap exposure that most small cap managers have in their portfolios. Small value funds average 29.28% exposure to mid caps, small blend funds average 24.85%, and small growth stocks average 24.05% exposure.
Usage in a Defined Contribution Plan
Circling around to the original question,"”Should mid cap stock funds be a part of a defined contribution investment lineup?" I come to the conclusion that generally the appropriate answer is "No." Before I explain why I do not think they should be included in an investment lineup, I want to clarify that I do not think it is imprudent to include mid cap funds within an investment lineup, or that these funds generally are in any way unsuitable investment options for participants to use within their portfolios. Our clients use a lot of mid cap stock funds and do so with a great deal of success.
As I looked to reach my conclusion it is unfortunate that there is not a silver bullet that I can point to that makes a decision easy. Ultimately it comes down to the totality of the information that is available.
In reaching my conclusion, I thought it first was important to note that an exclusion of mid cap stock funds from an investment lineup does not exclude mid cap stocks from an investment lineup. Using Russell’s methodology (because most investment managers use Russell’s indices) mid cap stocks make up approximately 800 of the names within the large cap universe (Russell 1000 Index) and are approximately 31% of the market cap of that index. The analysis of mutual fund portfolios also shows that mid cap stocks are well-represented within large cap mutual funds. Because of this, participants will have exposure to mid cap stocks through their large cap stock funds. Additionally, most small cap funds also have meaningful exposure to mid cap stocks. A portfolio that consists of both large and small cap stock funds will therefore generally include a large weighting to mid cap stocks, whether the investor intended it to have such an allocation or not. Adding a dedicated mid cap set of investment options therefore may result in participants over allocating to mid cap with exposure in nearly all active mandates.
Because mid cap stocks are represented in the investment lineup regardless of whether or not a dedicated mid cap fund is chosen, the determination as to whether mid cap stocks have a performance premium over large or small cap stocks is irrelevant. To the extent a return premium exists over large cap stocks, large cap managers could easily capture that premium by underweighting the largest stocks within their universe and overweighting the mid cap stocks to outperform the benchmark. If a return premium existed over small cap stocks, which I do not believe is likely, most small cap managers do have exposure to mid cap stocks within their portfolio and could outperform solely based on this exposure.
With the performance premium not being a deciding factor, I turn to whether a mid cap stock fund would provide a diversification benefit to investors using the investment lineup. I think the obvious answer to this question is that mid caps provide a marginal benefit at best. With correlations between the indices exceeding 0.90, the asset classes move pretty much in lockstep with each other. Mid cap stocks will provide little diversification benefit to a portfolio that is invested primarily in large cap stocks. A better diversifier, albeit still somewhat marginally, are small cap stocks.
Instead of serving as a diversifying asset within an investment lineup, I believe that a mid cap stock fund may actually be detrimental to many defined contribution participants because of its high correlation to large cap stocks. The negative impact does not come from the inclusion of mid cap stocks within the portfolio but from the fact that participants may be falsely led to believe they have a more diversified portfolio than they actually have. This "phantom diversification" is the result of many participants belief that if they own multiple mutual funds they have a diversified portfolio, regardless of what those funds actually have in their portfolio. Very few participants actually have the technical acumen to measure correlations, or look at underlying holdings, to determine whether the individual funds they own in their portfolio create a diversified portfolio. A participant that buys a large cap value stock fund as well as a mid cap value stock fund might think they are diversified but there is likely a high degree of overlap between the underlying stocks in both funds and the portfolio will get little diversification benefit from the two funds.
The "phantom diversification" concern is particularly acute in defined contribution plans because participants generally do not hold very many funds. Research has shown that the average number of funds held by participants is between 3 and 4. Given that the average participant may only own 4 funds, it would be especially troubling if two of those funds had correlations in excess of 0.90. Not using mid cap stock funds does not eliminate this problem, but it does reduce some of the redundancy that is included in many 401(k) investment lineups.
Also weighing in on my decision is the fact that a number of studies have shown that offering too many funds has a negative impact on participation rates and also increases the allocation to less risky assets. This is likely attributable to the fact that if participants are overwhelmed they will tune out or choose the "safe" choice, even if it has a negative impact on their long-term retirement goal. Because of these concerns, we are recommending, and clients are adopting, core investment lineups (excluding target date or target risk funds) that are limited 12-15 funds.
Within the constraints of a 12-15 investment array, a globally diversified investment lineup with a wide range of asset classes and risk/return profiles can be constructed. While historically many defined contribution plans may have offered a money market or stable value fund, an intermediate bond fund, U.S. equity funds in each of the 9 Morningstar "style boxes", and an international equity fund, this type of investment lineup results in participants weighting their portfolio heavily towards U.S. equity funds.
Plan sponsors are more frequently looking at reducing the number of their U.S. equity funds, and adding additional fixed income and international equity options to provide better options for their participants. The most recent bear market has accelerated that process as many plan sponsors realize they did not have enough diversification of the fixed income funds within their lineup. They also are realizing that the U.S. equity market is now less than 50% of the total global equity markets by market capitalization and a 9-to-1 ratio of domestic-to-international equity funds is inappropriate.
In summary, I think mid cap stock funds provide only a marginal benefit to participants seeking to build a diversified portfolio and in some cases they can be used inappropriately in a way that has a negative impact on participants’ portfolios. Couple this with the desire to add more diversifying asset classes to a 12-15 fund array and I think it is prudent for plan sponsors to avoid mid cap stock funds within their investment lineup.
† This White Paper is not intended to be legal advice and should not be construed as such. Information relayed herein is representative of the Multnomah Group’s experience and current understanding of the law. While the Multnomah Group has made every reasonable effort to ensure that the information contained herein is factual, we do not warrant its accuracy. Additionally, this White Paper does not embody a comprehensive legal study, but rather reflects the information most often sought by our clients. As the information contained herein is general in nature, you are urged to contact your legal adviser with specific questions related to your plan