A multifactor ETF investing approach for mid cap stocks

While U.S. mid cap stocks have provided solid returns over the long term, some investors miss out because they underweight the asset class and focus more on large and small cap companies. A multifactor investing approach in an exchange-traded fund (ETF) structure may make sense for mid cap exposure due to these stocks’ unique characteristics, opportunities and challenges. 

Mid cap stocks, which are roughly classified as those with a market capitalization of $2 billion to $20 billion, are often overlooked but have outperformed small and large cap stocks over the past 20 years. Superior earnings growth has provided a tailwind for mid caps.

Higher risk adjusted returns

 

20-year annual returns

20-year Sharpe ratio

U.S. small cap

9.43%

0.41

U.S. mid cap

9.98%

0.48

U.S. large cap

7.89%

0.40

Source: Morningstar, February 28, 2021. Chart data represented by the following indices: Russell 2000 Index TR USD, Russell Mid Cap Index TR USD; S&P 500 Index TR USD. Performance histories are not indicative of future returns. Indices are unmanaged and cannot be purchased directly by investors.

Higher earnings growth

Bar chart showing earnings per share growth percentages from December 31 2000 to December 31 2020.

A question of style

Investors trying to time their style exposure to mid cap growth and value funds hurt their performance, based on money-weighted returns, capturing less of the category average return than investors who stuck with mid cap blend strategies. Therefore, it could make sense for investors to simplify their allocations to mid caps. Money-weighted returns measure the performance of the average investor in the fund, based on net inflows and outflows of the fund.

Due to poor timing of buy and sell decisions, mid cap growth and value fund investors captured only about 85% and 73% of the category return, respectively.

Yet, mid cap blend fund investors fared the best with a 90% capture rate of category return. This is a key point. Style-timing decisions in mid caps reduced returns, which provides a strong case for moving away from targeted value and growth allocations and toward the center of the style box (blend).

Investors in mid cap blend strategies captured more performance than those in other mid cap categories

 

15-year category average return

15-year investor return

Captured return

Mid cap value

7.1%

5.2%

73%

Mid cap growth

7.3%

6.2%

85%

Mid cap blend

7.0%

6.3%

90%

Percentage of 15-year average return captured based on money-weighted returns
Only includes funds with at least $1B of assets. U.S. funds only, for informational purposes only. Source: Morningstar category data, as of 12/31/2018. Morningstar investor returns (also known as money-weighted or dollar-weighted returns) measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales. In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Past performance does not guarantee future results.

Picking a consistently outperforming mid cap manager is difficult

When deciding on an active or passive approach for individual asset classes, it may make sense to look at both the propensity of managers to outperform the index and the magnitude by which outperforming managers generate better results than the index.

Propensity = ability to outperform

Magnitude = amount of outperformance

Among the U.S. equity style boxes as defined by Morningstar, mid cap blend and mid cap value rank at the very bottom in terms of propensity to outperform, at just 27% and 29%, respectively, while less than half of mid cap growth managers outperform, at 44%. Meanwhile, in terms of magnitude, outperforming managers beat the index by the smallest degree in mid cap, with the top third of managers actually underperforming in mid cap value and blend.¹

Given that active manager selection is can be difficult in the U.S. mid cap space, investors may benefit from alternative approaches such as smart beta.

Putting it all together, an ETF that employs a multifactor approach may solve some of the challenges and capture the opportunities in U.S. mid cap stocks. A multifactor ETF may be able to target a wide range of mid cap stocks to access the breadth of the category’s opportunities, while emphasizing factors such as smaller cap, lower relative price and higher profitability that academic research has linked to higher expected returns.

Important disclosure

1 Source: Morningstar, as of 12/31/20. 

The opinions expressed are those of Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable, but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

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Value stocks may decline in price. Diversification does not guarantee a profit or eliminate the risk of a loss. It is not possible to invest directly in an index. Past performance does not guarantee future results.

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Jonathan d’Auvergne

Jonathan d’Auvergne, 

Director of ETFs

Manulife Investment Management

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