Investing in the sweet spot between small-cap risk and large-cap inertia.
What do Royal Caribbean, Starbucks and Salesforce have in common? Just nine years ago, in 2010, they were all mid-cap companies, with market capitalizations between US$4 billion and US$20 billion. Today, they have all graduated into the large-cap space, with market capitalizations of US$27 billion, US$94 billion and US$121 billion, respectively.1 Did you capture their potential as mid-caps?
Probably not, because many investors overlook the mid-cap opportunity. They concentrate instead on exciting but higher-risk small-caps or tried-and-true but slower-growth large-caps. However, the middle of the market is worth exploring too – especially because mid-caps have historically delivered significantly higher risk-adjusted returns than either small-caps or large-caps.2
Calculating the opportunity
For illustration purposes only. Source: Morningstar, July 31, 2019. Chart data represents the growth of the Russell 2000 Index TR USD, the Russell Mid Cap Index TR USD and the S&P 500 Index TR USD. Performance histories are not indicative of future returns. Indices are unmanaged and cannot be purchased directly by investors.
In the 20 years between July 31, 1999, and July 31, 2019, U.S. mid-caps (represented by the Russell Mid Cap Index) generated compound annual returns of 9.2 per cent. Meanwhile, U.S. small-caps (represented by the Russell 2000 Index) returned 8.0 per cent and U.S. large-caps (represented by the S&P 500 Index) returned 6.1 per cent. Furthermore, the 20-year Sharpe ratio (a measure of historical performance against risk) to July 31, 2019, was 0.45 for the Russell Mid Cap Index, but just 0.35 for the Russell 2000 Index and 0.31 for the S&P 500 Index.
Perhaps most importantly, as we head into a more uncertain economic environment, U.S. mid-caps have historically recovered better than large-caps. During the dot-com crash and the 2008 financial crisis, mid-caps took 745 fewer days and 290 fewer days, respectively, to recover from the market lows.
There are good reasons for mid-caps’ strength. These are businesses that have typically moved past the challenging start-up phase and can demonstrate the viability of their business model. They’re gaining scale, which brings efficiencies. They’re also acquiring experience, which helps them execute strategic plans more effectively. Yet many are also still growing rapidly, working hard to find new customers and build new solutions.
Because they’re still in an expansionary phase, their earnings per share can grow at a rate approaching that of small-caps. Between December 31, 1998, and December 31, 2018, for example, the Russell Mid Cap Index experienced compound annual earnings-per-share growth of 8.2 per cent. Over the same period, compound annual earnings-per-share growth was 5.7 per cent for the Russell 2000 Index and 6 per cent for the S&P 500 Index.3
Partner for results
So, the opportunity is there. The challenge is that mid-caps tend to get less analyst coverage than either small-caps or large-caps, which makes it harder to invest in individual companies with confidence. To capture broad market returns, an index fund may make sense – and one like the Manulife Multifactor U.S. Mid Cap ETF has the potential to provide a performance advantage.
The Manulife Multifactor U.S. Mid Cap Index ETF tracks the John Hancock Dimensional Mid Cap Index. Dimensional Fund Advisors designed the index to capitalize on factors academic research has shown tend to drive higher expected returns – specifically, smaller capitalizations, lower relative valuations and higher profitability.4 Overweighting any one of these attributes may deliver a return premium. Working together, they can significantly increase the probability of outperforming an index weighted only by market capitalization.
As Lukas Smart, one of the portfolio managers of Manulife Multifactor U.S. Mid Cap Index ETF, puts it, “We rely on the information that’s out there in the price in order to determine what factors will provide higher expected returns. [Then we deliver] systematic exposure to portions of the market … in a balanced fashion that takes into consideration the interaction amongst the dimensions, and takes into consideration the real-life costs of investing.”
The Manulife Multifactor U.S. Mid Cap Index ETF provides multifactor exposure to U.S. stocks that fall into the band between 200th largest and 950th largest companies. It has broad exposure to many industries – at July 15, 2019, its sector exposures were as follows:
Although still mid-caps, some of the Manulife Multifactor U.S. Mid Cap Index ETF’s holdings are already household names. Under Armour inspires athlete loyalty for its performance apparel and footwear. Etsy has staked its claim to handmade and vintage e-commerce. Tripadvisor is a go-to source of reviews that lead to bookings. Wayfair sells almost everything for the home with a product list topping 10 million. Zillow’s massive database has changed the real estate marketplace.
Many stocks in the Manulife Multifactor U.S. Mid Cap Index ETF have a compelling story of struggles and successes that ultimately result in the attractive mix of qualities Dimensional believes will provide higher expected returns. To avoid eroding returns with operational costs, Dimensional uses something it calls “Index Memory.”5
“Index Memory is really in its simplest form not paying a dollar to make 50 cents. You need to think about more than just expected return. There’s the cost of any given trade. And while it’s true that small changes in, say, relative price or total market capitalization or even profitability can give you some insight about the expected return, if that change in expected return is small, yet the cost of obtaining it is large, that’s not a sensible trade to do,” says Smart. “Index Memory is really how we’ve codified some of the role of the traditional portfolio manager at Dimensional and put it into the rules of the index. It’s striking that balance between the expected returns and the cost of effecting them in the portfolio.”
To that end, Dimensional uses hold ranges to expand the target range of securities and reduce unnecessary turnover – specifically, the Manulife Multifactor U.S. Mid Cap ETF has a target range of 600 securities but will hold up to 750 securities to minimize unwarranted trading costs. The portfolio managers don’t make small adjustments to security weightings that aren’t expected to meaningfully benefit returns or temper risk. They emphasize up-momentum securities during rebalance events to give the index, and thus the ETF, greater exposure to up-momentum securities. In addition, they schedule reconstitutions off-cycle, avoiding times when popular commercial indexes reconstitute their holdings and any associated pricing pressures.
“Dimensional has always been about taking some of the best ideas in modern finance and putting them to work in a real-life product,” says Smart. “At its heart, everything that we do is built around one central idea, and that’s that markets do a good job of incorporating information. They work. Intuitively, it’s something that we all grasp, [and] it gives us organizationally a focus and a framework to structure what we do and what we provide for investors.”
With a history of translating academic research into practical investment solutions since its inception in 1981, Dimensional is an ideal manager for advisors looking to capitalize on the U.S. mid-cap investment opportunity for their clients. The Manulife Multifactor U.S. Mid Cap Index ETF is a strategic way to offer investors both the low cost and transparency of a rules-based passive approach and the opportunity for outperformance through the active insight that informs the construction of the ETF.
Interested in learning more? Visit Manulifeinvestmentmgmt.ca for detailed information about the Manulife Multifactor U.S. Mid Cap Index ETF.