The base asset in many portfolios is large-cap U.S. equity. However, mid-cap U.S. equity is almost always included when advisors and investors assemble diversified portfolios. One way to see if this popularity is justified is to do an in-depth survey of mid-cap funds, and to see how these funds affect portfolio performance.
Using Morningstar Principia as the source of data for this study, there were 387 mid-cap U.S. equity funds (mutual funds and exchange-traded funds) in existence as of Nov. 30, 2011. This total included funds classified in the following Morningstar categories: mid-cap value, mid-cap blend, mid-cap growth, communications, consumer cyclical, consumer defensive, equity energy, financial, health, industrials, natural resources, real estate, technology and utilities.
Additionally, to qualify as mid-cap U.S. equity, funds that had more than 5% of their portfolio in bonds, non-U.S. equities or cash were excluded. Moreover, for funds offered in multiple share classes, only one share class of each fund was included.
The median market capitalization of these 387 mid-cap funds was $5.4 billion, with a maximum value of $10.7 billion and a minimum value of $2.1 billion. The largest 25 mid-cap U.S. equity funds (by total assets) are shown in "The Big 25" chart.
The largest 25 funds represent only 6.5% of all 387 large-cap U.S. equity funds, but hold just over 51% of the $279 billion in total assets, at $143 billion. The distribution of assets among mid-cap funds is extremely concentrated in the largest funds.
Of the 25 largest mid-cap funds, 10 are index-based funds. Those 10 index-based funds held $79 billion in assets - 55% of the assets among the largest 25 funds. It's worth noting that the five largest mid-cap funds are index funds, two of which are mutual funds; the other three are ETFs.
When looking at the entire population of 387 mid-cap U.S. equity funds, 152 are index funds, representing 39.3% of all mid-cap equity funds. The asset total in those 152 index-based mid-cap funds is $121.7 billion, or 43.6% of the $279 billion found in total mid-cap U.S. equity fund assets.
ETFs are firmly entrenched among mid-cap U.S. equity funds. Among the largest 25 mid-cap funds, seven of the 10 index-based funds are exchange-traded funds. Those seven mid-cap ETFs account for 30% of the $143 billion in assets among the biggest 25 mid-cap funds. Also, ETFs make up 79% of all index-based mid-cap funds, with 120 ETFs out of 152 index-based funds.
The final step in the analysis is to look at how each of the 12 largest mid-cap equity funds contributed to the performance of a diversified portfolio over the 10-year period from Jan. 1, 2001, to Dec. 31, 2010. The 12-asset portfolio consisted of equally weighted allocations (8.33%) in the following asset classes: large-cap U.S. equity, mid-cap U.S. equity, small-cap U.S. equity, developed non-U.S. equity, emerging non-U.S. equity, real estate, natural resources, commodities, U.S. bonds, TIPS, non-U.S. bonds and cash. The performance of each of the asset classes was represented by an established index - with the exception of mid-cap U.S. equity, which used each mid-cap U.S. equity fund in the model, one fund at a time.
The annual returns of the largest mid-cap U.S. equity funds were inserted into the 12-asset model. The 10-year performance of the entire portfolio is shown below in the "Portfolio Performance" chart.
You may have noticed that seven of the 25 largest mid-cap U.S. equity funds are real estate funds. These sector funds were omitted from this part of the analysis because real estate is already one of the 12 asset classes included in the diversified portfolio. Moreover, another six mid-cap funds did not have a full 10-year performance history as of Dec. 31, 2010, and were also omitted.
That is why only 12 of the 25 largest mid-cap funds ended up in the portfolio analysis. Despite the performance differences among the individual mid-cap funds (as listed in "The Big 25"), the 10-year annualized return of a 12-asset portfolio was largely unaffected by which mid-cap U.S. fund was used.
The biggest performance difference - at the portfolio level - was observed when using Franklin Small-Mid Cap Growth as the mid- cap U.S. equity fund vs. Aston/Fairpointe Mid Cap. If using Franklin Small-Mid Cap Growth in the 12-asset portfolio, the 10-year portfolio return was 8.47%, whereas the 10-year annualized return was 9.13% using the Aston fund. A difference of 66 basis points is not trivial, but it's not dramatic, either.
NO PERFECT FUND
The data in "Portfolio Performance" illustrate a vitally important point - the asset allocation model is more important than the individual fund being used in the model. As shown, there are a number of perfectly adequate mid-cap U.S. equity funds in terms of performance. Really, any of these funds will work. The most important issue is to build a broadly diversified portfolio - rather than getting hung up on picking the perfect mid-cap fund.
It is possible that some other issue might distinctly favor one fund over another, such as tax efficiency (see "The Big 25" chart), minimum initial investment requirement or some other logistical component of a particular mid-cap fund.
Consider this: The best mid-cap U.S. equity fund for use in a broadly diversified portfolio may not be the fund with the highest return. Rather, the best mid-cap fund (or fund in any of the various asset classes) is the one that adds the most value to the overall portfolio.
It is instructive to note that Aston/Fairpointe Mid Cap did not have the highest 10-year return in "The Big 25" as of Nov. 30, 2011. Nor did the Aston fund have the highest 10-year return over the 10-year period ending Dec. 31, 2010.
Nevertheless, it was the mid-cap U.S. equity fund that blended with the other 11 asset classes to produce the highest return for the overall portfolio. The reason for that appears to be the advantageous timing of the returns of the Aston fund in relation to the timing of the returns of the other portfolio ingredients. It's really all about maintaining low correlation among the portfolio ingredients.
This is a crucial observation, because mutual funds are often selected on the basis of their own individual performance when, in reality, the most important determinant in selecting a mutual fund should be how well it contributes to the performance and risk attributes of the overall portfolio in which the fund will be used. The bottom line is that a five-star fund on its own may not be a five-star teammate in a broadly diversified portfolio.
Craig L. Israelsen, Ph.D., is an associate professor at Brigham Young University and the author of 7Twelve: A Diversified Investment Portfolio With a Plan.