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Mid Caps Married With a Multi-Factor Strategy

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There is a lingering dichotomy with mid-cap stocks. The asset class is often referred to as the “sweet spot” of the equity market. Simultaneously, mid caps are widely viewed as overlooked.

Another widely held fact about mid caps is these stocks often outperform large caps while delivering less volatility than smaller stocks over long holding periods. Historical data confirm as much. From March 10, 2009, the start of the current U.S. bull market, through Sept. 24, 2018, the S&P MidCap 400 Index returned 428.5 percent compared to 391.8 percent for the S&P 500. The mid-cap benchmark barely trailed the Russell 2000 Index while delivering less annualized volatility and a smaller maximum drawdown than the small-cap index.

Despite those impressive statistics, mid-cap stocks do live up their overlooked billing, a phenomenon seen in the world of exchange traded funds (ETFs). Of the 100 largest US-listed ETFs by assets, just five are mid-cap funds.

A growing number of mid-cap funds offer exposure to multi-factor strategies, which could help lure factor investors to the mid-cap sweet spot. The JPMorgan Diversified Return U.S. Mid Cap Equity ETF (JPME) is one of those funds. JPME’s security selection process focuses on the value, quality and momentum factors.

Assessing The Mid-Cap Premium

Small stocks, including mid caps, often command premiums relative to large caps, a notion confirmed by the 2018 study “The Curious Case of the Mid-Cap Premium.”

“The study confirms the existence of the mid-cap premium and finds that exposures to the size and profitability factors may explain this premium,” notes the study’s author, Wei Ge. “The mid-cap premium may help investors improve portfolio performance without adding significant extra risk, yet investors must fully understand the specific mid-cap index they intend to use to avoid causing distortions to their portfolios.”

That premium exists, in part, because mid-cap stocks usually display higher earnings growth and more market sensitivity than large-cap equities. Size, though not a factor explicitly targeted by the JPMorgan Diversified Return U.S. Mid Cap Equity ETF, can also affect mid-cap performance and volatility. The standard definition of mid-sized stocks caps market values at $10 billion. As the chart below indicates, the JPMorgan Diversified Return U.S. Mid Cap Equity ETF exceeds that, but still offers mid-cap exposure than the benchmark and the average fund in the Morningstar mid-cap blend category.

Courtesy of Morningstar

Enter Value

With mid caps, discussing premiums and value is not as counter-intuitive as it initially appears. For a variety of reasons, quality (one of the factors emphasized by JPME) mid-cap companies may also be value ideas. Profitable, well-managed mid-cap companies can trade at discounts to intrinsic value or growth potential.

Additionally, analyst and investor neglect of mid caps can create valuation opportunities. While factors can provide alpha over the long haul, there is no guarantee that a single factor strategy will deliver the desired, market-beating outcome.

Related: A Multi-Factor Approach For Globetrotting Investors

Related: Small Stocks, Big Multi-Factor Advantage

As the chart below indicates, JPME, since inception, has easily topped the Russell Mid-Cap Value Index.

In the current strong dollar environment, mid caps’ domestic orientation and earnings steadiness potentially make the asset class attractive. Even if the dollar declines, mid-cap stocks can benefit. Actually, mid caps benefit the most from dollar retrenchment.

“For every 1% drop in the U.S. dollar, the S&P MidCap 400 (TR) rises 3.20% on average,” according to S&P Dow Jones Indices.

For the third quarter, as of Sept. 25, the U.S. Dollar Index is up just 0.08%, but JPME is up 3.51%.

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