From the May 2006 issue of Wealth Manager Web • Subscribe!

In Medias Res

Maybe these are the funds Goldilocks was looking for: The small caps were too volatile, the large caps did not provide enough growth potential, but the midcaps were just right. Actually, midcaps are more than just companies too big to be small and too small to be big. They have some significant attributes all their own.

First, we have to come to some agreement about what a midcap is. Forbes defines a mid-cap company as one with a market capitalization between $1 billion and $4 billion and says 1,000 U.S. companies fit that description. The T. Rowe Price Mid-Cap Growth Fund, for example, says it invests in companies whose market capitalization falls within either the S&P Midcap 400 Index or the Russell Midcap Growth Index. The latter includes companies between $959 million and $22.681 billion. The William Blair Mid Cap Growth Fund invests in companies with market capitalizations between $1.5 billion and $14 billion. Other mid-cap funds have similar size ranges depending on the manager's style and investment goals.

Another way to look at them is as more flexible large caps, or more stable small caps: Like their larger counterparts, mid-cap companies offer established products, have experienced management teams and a proven track record, but like smaller companies, they can offer good growth potential. Having successfully weathered their start up years, mid-cap companies have the resources to finance their own growth and take advantage of new market opportunities.

According to Todd Trubey, a mutual fund analyst with Morningstar in Chicago, many small caps tend to be one-product or one-customer companies, which creates some real fundamental risk for investors. Mid-cap companies, on the other hand, have more diversified customer and product lineups. Correspondingly, the stocks have a higher long-term reward potential than large caps but lower volatility than small caps. "The stock price won't decline as much if the company loses one customer," Trubey says.

A mid-cap company's size and maturity also mean fewer earnings surprises than found with smaller companies. In addition, midcaps are frequently seen as merger bait for larger companies and may pay out a greater portion of earnings as dividends.

A Class of Their Own

For Phyllis Bernstein, CPA, president of Phyllis Bernstein Consulting in New York City, the big question is whether advisors should treat midcaps as a separate asset class. "Mid-cap stocks account for approximately 10 percent of the total U.S. equity market capitalization. Yet many investors don't recognize midcaps as a distinct asset class. They focus their attention on larger companies or on a combination of large- and small-cap stocks." Many of the CPA investment advisors she works with, however, do use midcaps as a separate asset class when designing portfolios.

In 2005, Bernstein says, size did matter. The S&P 500 Index returned 4.9 percent, versus 12.6 percent for the S&P MidCap 400 Index and 7.7 percent for the S&P SmallCap 600 Index. But, she says, large-cap stocks didn't do as poorly as the S&P 500 suggests: "The poor performance of the 100 largest stocks in the index helped drag down the capitalization-weighted index," she explains.

To gain mid-cap exposure Bernstein says she sees some advisors using the S&P MidCap 400 SPDR (MDY). This exchange-traded fund closely tracks the index's returns and charges a low 0.25 percent expense ratio. Advisors, she says, can also use exchange traded funds for mid-cap value or growth based on the Russell mid-cap index iShares managed by Barclays Global Fund Advisors.

Does all of this mean you should include mid-cap mutual funds in the portfolios you create for your clients? According to Bernstein, that depends on whether your clients already hold the total stock market in a broad index fund. In the final analysis she personally believes "it makes more sense to buy an index fund that tracks the entire market," than to pursue each segment separately.

The Big Picture

Thomas B. Gau, CPA, CFP, president of Retirement Planning Specialists, in Ashland, Ore., says mid-cap funds don't so much meet specific client goals as they work together with small- and large-cap funds to satisfy the client's overall objectives and risk tolerance. With so many client portfolios lacking proper diversification, Gau says advisers need to educate clients about mid-cap funds and the role they can play. After all, he says, "How many clients even know what a mid-cap stock is?"

For a hypothetical moderate-risk investor, Gau--who heads an independent financial planning firm--might allocate 30 percent to fixed-income and 20 percent to international markets, leaving 50 percent for small-, mid- and large-cap domestic stock mutual funds. "Since larger cap companies generally have lower volatility, I typically recommend that half of the stock allocation go into large-cap funds and the balance be split between small- and mid-cap domestic funds."

In selecting a mid-cap fund, Gau looks closely at how the manager defines midcap to make sure the client is getting what he or she wants and needs. "If two mid-cap funds own 90 percent of the same stocks, that really isn't diversification." At some point, however, advisors have to ask how much they should micromanage by looking too closely at what individual stocks the manager buys. For Gau, the bottom line is, "I try to pick mutual funds that complement each other."

Martha K. Pomerantz, a principal of Lowry Hill, a Minneapolis firm that provides wealth management services to high-net-worth families, thinks large-cap stocks are more attractive than mid-cap stocks right now. Co-chair of the firm's investment committee, Pomerantz says, "Mid-cap companies have had above average profitability characteristics. This is well reflected in their stock prices, which have outperformed over long periods of time--one, three, five and 10 years."

Pomerantz says most investors should have some exposure to the different areas of the market--be it small, medium or large cap. But advisors should use some caution in deciding how their clients get that exposure. "If you buy the S&P 500, which many people do, you already own a significant portion of the mid-cap sector and don't need to seek it out elsewhere." To avoid overlap, Pomerantz suggests advisors explore what other index they might buy. For instance, she says "the Dow Jones is just above the mid-cap category. It's smallest market capitalization is $18 billion," the top range of some midcap definitions.

What Price Success?

Some experts say that one reason why midcaps have done so well recently is the amount of hedge fund money invested there. As these funds grow and seek to buy more stock, additional capital flows into companies of this size, driving prices up. But according to Pomerantz, "this outperformance has been going on for a long time, so it's not just hedge funds." Still, she cites a February 2006 Morgan Stanley Equity Research Report which shows that while only 27.6 percent of the Russell 3000 is concentrated in mid-cap stocks, 42.7 percent of hedge fund money is invested in the sector.

The active presence of hedge funds in the market is just one risk of mid-cap investing. "Because midcaps are smaller companies," Pomerantz says, "they tend to be more volatile. The beta, or measurement of risk, tends to be higher than average. And because these stocks have done well in the last three, five and 10 years, the valuations might be somewhat extended." She cautions that investors need to be careful about "buying into last year's story" and investing in mid-cap mutual funds after the valuations have already run up. "The top 50 mid-cap companies were up an average of 40 percent to 50 percent last year. So some portion of this index is well above average. Advisers shouldn't expect returns to compound at that rate," she warns.

Instead they should ask themselves what the attractive asset class is going forward. Pomerantz argues that large caps are the most attractive class right now. "The midcap class is well-recognized, and there have been some strong gains. But the relative valuation is higher than the alternatives and will exhaust itself at some point." Because the growth has been so great, she says advisors should exercise some short-term caution. However, over longer periods of time, Pomerantz thinks owning funds that invest in mid-cap companies "offers an opportunity to make money."

Too Late in the Game?

As both Bernstein and Pomerantz have noted, mid-cap stocks tended to outperform both their small and large cap counterparts last year. When that happens, Morningstar's Trubey says the tendency is for investors to say, "That's hot; I should get into that," and chase performance that is already gone. But that doesn't mean midcaps won't lead the way again. "The right way to look at it is to say there will be years like 2005 when mid-caps will do better than both small and large caps. That means my overall portfolio should have some mid-cap exposure."

Trubey says now is a good time for advisors to check their clients' portfolios. If they are light in midcaps, they can search for a mid-cap mutual fund that will do well over the longterm. "Mid-cap funds may or may not do great this year, but over the long term they are something you want in your portfolio."

What should advisors look for in selecting a mid-cap fund? Trubey says in general you should seek the same things you look for in any other mutual fund investment--"low expenses, a coherent strategy that can yield strong repeatable results and a manager who can execute that strategy." Echoing Pomerantz, he says if there is one thing that is different with mid-cap funds, it lies in the fund's definition of mid-cap. "Depending on what the rest of your portfolio looks like, you don't want to accidentally overload on small- or large-cap stocks. You need to look at your overall portfolio and choose a fund that complements the others you already own." Depending on what funds the client has already invested in, Trubey says, advisers may find they already have plenty of mid-cap exposure and may not need to purchase a dedicated mid-cap fund.

Growth with Caution

Through it all, mid-cap mutual funds and the stocks they invest in seem to be an attractive market segment with high growth potential. However, considering the considerable gains in this area in recent years, it's more important than ever for advisors to keep in mind that key financial mantra: "Past performance is no guarantee of future results."

Peter D. Fleming is a freelance business and investment writer in New York City.


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