April 19th, 2011
Guest Author: Ridgeworth Investments, an investment adviser registered with the SEC, also serves as a holding company that owns interests in eight investment boutiques. See Ridgeworth.com.
· Long record of outperformance – Mid-caps have outperformed other cap sizes over the long-term as of December 31, 2010.
· Consistent record of outperformance – Mid-caps have outperformed large caps and small caps for the majority of rolling periods within the last 30 years.
· Better risk/reward relationship – In the majority of periods ranging from one to 30 years, mid-caps have had a higher Sharpe ratio than other cap sizes. (See chart below)
· Strong risk-adjusted return over full market cycles – Mid-caps have historically outperformed small caps heading into recessions and large caps coming out.
· Strong position in the current market environment – Mid-caps have historically done well in the periods following market bottoms.
· Positive addition to an allocated portfolio – Adding an allocation of up to 40% in mid-caps has improved the risk/reward relationship of portfolios that only had large cap and small cap allocations.
· A Long Record of Outperformance
· A Consistent Record of Outperformance
· A Better Risk/Reward Relationship
· Performance over Economic cycles
· Mid-Caps and the Current Market Environment
Mid-cap stocks have often been left out of basic asset allocation models, to the detriment of long-term investors. Although they make up approximately 27% of the domestic equity universe, only 15% of mutual fund assets invested in Morningstar’s domestic equity style box are invested in funds that are classified as mid-cap (as of 12/31/10).
Mid-caps have outpaced large and small caps over the past 30+ years, and have beaten them in a majority of rolling periods within it. They have generally protected the downside better than small caps going into recessions and bounced back faster than large caps coming out – providing a risk-adjusted return that has been superior to both. A portfolio that included a specific allocation to mid-cap stocks had a better risk/reward relationship than a portfolio without over both short and long time periods.
Those who invested in funds benchmarked to the Russell 1000 Index in an attempt to satisfy mid-cap exposure have generally not realized the full benefits of mid-caps. The mega-caps within the Russell 1000 (Russell 200 Index) have had a disproportionate impact on the returns of the Russell 1000 over the past 30 years, dampening the positive impact of the mid-caps in the index. If an investor has not made a specific allocation to mid-caps, now may be an opportune time to add them.
A Long Record of Outperformance
An investment in mid-caps in 1979 would have significantly outpaced large and small caps over the next three decades. (See Exhibit 1) A $10,000 investment in mid-caps would have grown to $588,474 — $238,000+ greater than either large or small caps.
The historical performance of mid-caps becomes more impressive when analyzing time periods that span 30 years. For the period ending 12/31/10, the annualized returns of mid-caps were higher than the other two market caps for the five-, 10-, 15-, 20-, 25- and 30-year time periods.
Mid-cap’s long-term outperformance may be attributed to a number of factors, including:
Mid-cap companies are typically small cap companies that have succeeded. Mid-caps have already progressed through small cap status, and are likely to have proven business plans and more experienced management.
Mid-cap companies typically have greater financial liquidity and better capital-raising ability than small caps. Mid-caps are generally better able to withstand the depths of a downturn than small caps to emerge in a stronger financial condition when the economic environment improves.
Mid-cap companies typically have higher earnings acceleration compared to companies in other cap sizes. Mid-cap companies are often in the growth phase of the business lifecycle, experiencing higher earnings growth relative to small caps who are typically still trying to establish their business models and market positions. Relative to their “mature” large cap counterparts who have substantially penetrated the lion’s share of the market, mid-caps generally have ample opportunity for growth.
Mid-cap companies typically receive less analyst coverage than large cap companies. The less coverage a particular segment receives, the more likely there are market inefficiencies to exploit. The fact that there is less overall research for mid-caps than large caps suggests that there are greater opportunities for active managers to capitalize on inefficiencies in the mid-cap market.
Mid-cap stock outperformance has been consistent over time. Over rolling time periods ranging from one to 10 years, mid-caps have outperformed large and small caps well over half the time. In rolling 10-year periods, mid-caps outperformed small caps every single time. (See Exhibit 3 and visit Add Mid-Cap to test the claim.) The importance of the 10-year period, where mid-caps have exhibited their highest rate of outperformance, is that it has often captured both recessionary and expansionary periods. The most recent 10-year period includes the recent recession that began in December 2007 and ended in June 2009, the previous recession which lasted from April 2001 through November 2001 and the expansionary period in between.
A Better Risk/Reward Relationship
Though mid-caps have exhibited volatility levels that are more consistent with their small cap peers over recent years due to equity market uncertainty, over longer time periods the standard deviation of mid-caps has been closer to large caps. Over the long-term, higher absolute returns relative to both large cap and small cap stocks and standard deviation that is more aligned with large caps has provided mid-cap investors with a superior risk/reward relationship. Using the Sharpe Ratio as a measure of risk/reward, mid-caps had a higher Sharpe Ratio than large and small caps over the one-, five-, 10-, 15-, 20-, 25- and 30-year time periods. (See Exhibit 4)
Upside/downside capture is an alternative method for analyzing the relative risk of an investment. For the vast majority of rolling periods over the last 30 years, mid-caps have participated in the majority of the upside relative to other cap sizes, while avoiding much of the downside of small caps. (See Exhibit 5)
Performance Over Economic Cycles
Economic cycles are loosely defined as fluctuations in growth patterns caused by overall economic and financial trends, competitive forces as well as the nature of supply and demand. While these cycles may be predictable in pattern, they are rarely predictable in duration.
The current equity market is no exception. While the most recent recession was the longest since World War II (18 months), the market has exhibited familiar patterns relative to past recessions – notably the 1980, 1982, 1991 and the 2001 recessions. For instance, the market experienced a 4.12% increase in the six months following the recession end in June 2009 and a 9.23% return after 12 months. (See Exhibit 6) The exhibit shows that on average, the six-month return following a recession end is 4.77% and 6.99% after 12 months.
Looking back on the four past recessions, bear markets, on average, have bottomed four months prior to the official end of the recession. Another familiar pattern has been the performance of mid-caps relative to large caps (represented by the S&P 500) around the market bottom. The exhibit clearly illustrates that as the market approaches the bottom, mid-caps have tended to underperform large caps, but once the recession end is established, mid-caps have progressively outperformed large caps as the economy recovers. This illustration of the economic cycle suggests that mid-cap stocks tend to underperform large caps when investor fear and risk aversion are rising, but steadily outperform as investors regain confidence in the market.
The “Change in Ratio” compares the ratio between the value of the mid-cap index and the large cap index over designated time periods. A positive number indicates that mid-caps outperformed large caps over the period and a negative number would indicate that large caps outperformed mid-caps. For example, the ratio of the two indexes at the end date of the 1980 recession was 10.07. Six months later, the ratio was 10.24. The ratio increased by 1.69%, indicating that the mid-cap index outperformed the large cap index by 1.63% over the period.
Bear market bottoms have occurred an average of four months before recession end dates.
Mid-Caps = Russell Mid-Cap Total Return Index Large Caps = S&P 500 Total Return Index
Monthly Data Starting in 1978
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The CBOE Volatility Index (VIX) is a measure of expected volatility. Often referred to as the “investor fear gauge,” the VIX is a forward-looking metric that uses S&P 500 Index options to indicate the market’s expectation of 30-day volatility. A measure of less than 20 reflects expectations of relatively low volatility, while higher than 30 indicates relatively high volatility.
Exhibit 7 shows the relationship between the VIX and the ratio between mid-cap and mega cap returns over the past 20 years. The graph demonstrates that there has been an inverse relationship between mid-caps (relative to mega caps) and volatility. When volatility spiked, the ratio between mid-caps and mega caps declined, as mega caps outperformed mid-caps. As volatility receded, the ratio increased indicating that mid-caps outperformed mega caps.
The volatility spikes occurring during the 1990s recession coincided with a period of mid-cap underperformance. During the expansionary period between 2003 and 2007, volatility measures fell below 20 and mid-caps enjoyed a period of escalating outperformance. In late 2008, expectations of volatility spiked to 80, corresponding with a brief period of underperformance for mid-caps, but when expected volatility decreased mid-caps began outperforming again.
The opposite relationship has generally been true when comparing mid-caps to small caps. (See Exhibit 8.) When expected volatility was rising, mid-caps usually outperformed small caps. Immediately after periods of high volatility, small caps have tended to outperform mid-caps. In 2008, the relationship broke down for a brief period after Lehman declared bankruptcy and volatility soared. Some believe that the environment drove many mid-cap investors out of the market, negatively impacting performance while speculators dampened the negative impact on small caps.
Mid-Caps and the Current Market Environment
With the lingering effects of the Great Recession still in play – including near-zero rates of return and continued economic uncertainty – a number of current and expected environmental factors bode well for mid-cap stocks and active mid-cap managers.
· Increasing (albeit cautious) investor risk appetites – Investors are growing weary of the near-zero rate environment and are beginning to dip back into the equity markets again. According to ICI, stock funds posted an outflow of $24 million in October, an inflow of $511 million in November and an inflow of $826 million in December.
· Recent outperformance of Consumer Discretionary and Consumer Staples – The Consumer Discretionary sector, which is believed to be an indicator of the U.S. economy’s health, outperformed the Consumer Staples sector in the fourth quarter of 2010. This trend is expected to continue. In the fourth quarter, Consumer Discretionary returned 12.45% within the Russell 3000 Index, while Consumer Staples returned 7.04%. Mid-cap indices have greater exposure to cyclical sectors such as consumer discretionary.
· Expected emphasis on quality – During the market’s initial recovery, it decidedly favored low quality stocks that suffered severely during the downturn; however, it is generally agreed that over longer time periods, quality stocks prevail. This is good news for active fund managers, who may have lagged their benchmarks because of quality-based investment parameters.
· Escalating Mergers and Acquisitions activity – As valuations continue to improve and credit markets loosen, M&A activity may increase. Growing M&A activity has historically benefited the mid-cap sector; mid-cap companies have been popular acquisition targets and have often sold at a premium. We believe that at some point, companies will stop hoarding their cash and look to expand their businesses by focusing on M&A.
With these factors at play, we believe that investors should benefit from an allocation to midcap stocks. Not only will an allocation to mid-caps help diversify investor portfolios, but it has proven to enhance returns with only minimal additional risk. Exhibit 9 illustrates the benefit of making an allocation to mid-caps and highlights that portfolios with higher allocations to midcaps experienced the greatest benefit.
While investors’ allocations to mid-cap should be consistent with their risk tolerance, including a mid-caps allocation has historically resulted in improved portfolio performance with a minimal increase in risk. Reallocating from large caps to mid-caps has improved the diversification of the portfolio and resulted in better risk-adjusted returns.
Despite the many threats to economic stability including high unemployment, a weak housing market and the euro-debt crisis, we are cautiously optimistic about the continuing economic recovery in 2011. Over the past several months we have seen a number of positive signals that indicate the market is poised to continue its upward swing. Solid company earnings, increased consumer confidence and higher consumer spending levels have all served the equity markets well over the past year. We anticipate that these trends will continue.
We expect that investors with an increased appetite for risk will be more aggressively moving back into the equity market given the continued low-rates of money markets and the concerns about a potential bond bubble.
Investors who are ready to re-enter the equity markets may be well served by adding an allocation to mid-caps as part of a diversified portfolio because over the long-term, mid-caps have had:
· Consistent outperformance relative to large caps and small caps.
· A better risk-reward profile than other market cap sizes.
· Less extreme behavior under changing economic conditions.
· Favorable characteristics regardless of economic environment.
We believe that an analysis of mid-caps relative to other capitalization segments reveals the continuing strength of mid-caps as part of a diversified investment portfolio.
Benefits of Dividend Paying Stocks by Ridgeworth Investments