Investors building a diversified portfolio should consider the merits of a multifactor smart beta ETF approach to access this segment of the market.
On the recent webcast, Discover the Sizable Opportunity in Mid Caps, Matt Miskin, Market Strategist for John Hancock Investments, argued that mid-caps are the “sweet spot” of the market, describing these companies as large enough to have well-established management teams, broad distribution channels and ready access to capital market, along with the benefit of growing more quickly than their large-cap counterparts as they are less bogged down with bureaucracy and maintained a more entrepreneurial spirit.
Mid-caps have also exhibited long-term outperform with less risk. The middle capitalization segment offered the highest percent positive quarterly excess return compared to the Russel 1000 over the past two decades when compared to its small- and large-cap counterparts. Additionally, the Russell Midcap has also produced the highest return per unit of risk or a high Sharpe ratio over the past 20 years as well.
In an attempt to screen out the relevant information in the market place as a way to hone in on attractive market premiums, Joel Schneider, Senior Portfolio Manager for Dimensional Fund Advisors, explained that they try to target four factors that have historically helped drive expected market returns, including the equity premium, small-cap premium, value premium and profitability premium.
“Academic research has shown that stocks characterized by smaller capitalizations, lower valuations and higher profitability have delivered higher expected returns over time,” Schneider said.
Schneider showed that investors will find pretty meaningful premiums when screening for these four factors. For example, for the period of 1927 through 2017, picking stocks over bonds helped produce a premium of 635 basis points of incremental return, smaller companies over larger produced 224 bps, relative value over growth generated 333 bps and higher profitability over lower added 287 bps.
Factors May Perform Differently in Various Market Conditions
However, Schneider warned that the factors may perform differently in various market conditions.
“Over time, factors will provide alpha. The problem we face as investors is that by investing in just one single factor, there is no certainty that over time, one particular factor will generate the sought after premium,” Schneider said.