(PUB) Investing 2016

and losses. It’s the middle ground, like the proverbial middle child, that gets ignored. As a result, investors may be missing a wonderful opportunity, considering that long-term mid-cap index returns tell a pretty bullish story. The chart to the left of the relative performance of various Russell indexes over the 37 years they’ve been calculated shows that over the long run, mid-cap stocks have outpaced both their larger and smaller siblings. The blue line com- pares the Russell Midcap Index and the large-cap Russell Top 200 Index. When it is rising, mid-cap stocks are outperforming large-caps. The black line compares the mid-cap index to the small-cap Russell 2000 Index, and again, it rises when mid-caps outper- form. To put some numbers behind the chart, over more than three decades, the Russell MidCap index returned 13.2% a year—about 2% better per annum than both the large-cap Russell Top 200 and the small-cap Russell 2000 indexes. A 2% annual advantage may not seem like much, but it really adds up over time. One hundred dollars invested in the Russell Midcap Index at the end of 1978 would have grown to $10,501 by the end of July 2016. Meanwhile, a similar investment in large-cap stocks (Russell Top 200 Index) would have grown half as much, to just $5,239. And small-cap stocks, as measured by the Russell 2000 Index, would have turned that $100 into $5,385. As the chart shows, this return edge is not the result of one outstanding period, as mid-caps held their advan- tage in many different environments and cycles. An investment rule of thumb is that with higher returns comes higher risk, but mid-cap stocks turn that chestnut upside down. The table on page 13 shows the maximum cumulative loss (or drawdown) and the time it took to recover from the losses for the Russell indexes during the four big bear mar- kets of the past 37 years. The Russell Midcap Index’s steepest decline— a loss of 54.2% reached during the

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Mid-Sized Companies, Outsized Returns

in a company with a market cap of $2 billion. (Remember, market cap is a measure of a company’s size, and is calculated by multiplying the stock’s price by the number of shares outstand- ing.) The first fund—let’s call it Small Fund—has $2 billion in assets, while the second fund, Large Fund, has $10 billion. If the manager of Small Fund wants to establish a meaningful 2% position, she would buy $40 million of the company’s stock, or 2% of all shares outstanding. If the manager of Large Fund buys the same $40 million of the company’s stock, the resulting position will only be 0.4%—not exactly moving the needle. For Large Fund to hold the same 2% position, the manager has to buy $200 million of the com- pany’s stock, or 10% of the company. That’s why it becomes increasingly harder to buy and sell small- and mid- sized stocks as fund assets expand. One way to defend against asset levels growing too big for the strategy (some- times referred to as asset bloat) is to close the fund—but even this may not be enough. For years, Capital Opportunity was the single best aggressive small-/ mid-cap fund Vanguard offered, and if you’ve followed Dan’s and my advice to buy and hold this PRIMECAP- managed fund, you’ve reaped the rewards. But as we’ve discussed in the past, its increase in assets means that while still a great fund, it is no longer a great smid-cap fund. Yes, Vanguard has on occasion closed funds, but the preferred solution seems to be to just add another man- ager to the portfolio. Doing so keeps any single manager from having too many dollars to invest, but it comes at a cost: The portfolio and performance get watered down and begin to look like the index. Think of Explorer and the seven different management firms stirring its pot. It’s going to be difficult to serve up an appetizing meal with that many chefs in the kitchen. Maybe Vanguard’s recent moves to slim the manager ranks at Explorer Value and International Growth indi-

2.25

Mid-Cap/Large-Cap Mid-Cap/Small-Cap

2.00

1.75

1.50

1.25

1.00

0.75

7/80

7/83

7/86

7/89

7/92

7/95

7/98

7/01

7/04

7/07

7/10

7/13

7/16

cate a lasting change in the firm’s approach to the multimanager strategy? I hope so. The combination of ever- larger funds and Vanguard’s misguided commitment to the multimanager for- mat are why I suggest that investors looking for some pop from their stock funds and unwilling to look outside the Vanguard fold may find an index fund to be their best option. A Market Sweet Spot All is not lost. Investing in some of these aggressive funds can still yield decent rewards, and in a minute, I’ll sort out the active and passive funds in this group in more detail. But first, let’s take a closer look at mid-cap stocks, because if there is a sweet spot in the market for portfo- lio growth, mid-sized companies fit the bill. Many mid-sized companies exhibit the growth characteristics of small companies and the financial sta- bility of large ones, yet they are often overlooked by investors. Why? Well, the largest publicly traded companies garner the attention of Wall Street banks because of the hefty investment banking fees they pay on stock offerings, bond issuance, advice on mergers and acquisitions, etc. The media focuses its attention on the large “household name” com- panies, because it makes their sto- ries relevant to the listeners’ lives. At the same time, smaller companies, with their higher risks and higher potential returns, grab the attention of risk-takers and provide the sizzle of sometimes daily double-digit gains

12 • Fund Family Shareholder Association

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