Exchange traded fund investors can consider focusing on middle capitalization-weighted company exposure to enhance their portfolio.
“Powered by earnings growth, mid-caps have generated consistent outperformance over rolling periods relative to large and small caps,” Matthew Miskin, Co-Chief Investment Strategist, John Hancock Investment Management, said in the recent webcast, Mid-Cap ETFs: Why Diversifying Away From Mega-Caps Makes Sense Now.
When looking at historical data from January 1996 through June 2020, Miskin pointed out that mid-caps generated 6.36% earnings growth, compared to the 5.24% for large-caps and 0.88% for small-caps.
Miskin also argued that this asset category reflected a higher conviction part of the global equity markets with greater catch-up potential. Looking ahead, mid-cap stocks could offer a more attractive post-recession opportunity. Middle-capitalization stocks combine the growth potential of younger companies with financial stability often associated with larger companies to provide investors with the best of two worlds.
Joseph Hohn, Senior Portfolio Manager, Dimensional Fund Advisors, argued that investors could gain better market exposure through a rules-based approach through improved index design, such as a factor-based or smart beta ETF strategy.
To help investors better access these factor strategies to enhance returns and diminish downside risks, John Hancock Investments has partnered with Dimensional Fund Advisors to launch several factor-based ETF strategies. Hohn outlined four major factors that help drive expected returns for their smart beta strategies, including the equity premium, small-cap premium, value premium, and profitability premium.
Specifically, the market equity premium reflects the outperformance of stocks over bonds. The small-cap premium corresponds to the outperformance of small-caps over large-caps. The value premium relates to value stocks over growth stocks. Lastly, the profitability premium shows that highly profitable companies tend to do better than less profitable companies.
Hohn also highlighted a study conducted by the University of Chicago Professor Eugene Fama and Dartmouth College Professor Kenneth French that found focusing on smaller stocks and those with lower relative prices may improve a portfolio’s expected return. Additionally, in a separate research paper, profitability is seen as another factor that enhances expected returns over time.
When combined, the various factors may help improve a portfolio’s risk-adjusted returns over time. Hohn explained that the Dimensional Fund Advisors’ multi-factor strategies select securities of a specific sector with a desired market capitalization range, with an increased emphasis on higher expected return securities. The securities will exhibit lower relative price, higher profitability, and lower market capitalization. Moreover, securities’ weights are capped to diminish concentration.
Hohn pointed out that smart beta middle-cap ETFs is backed by incremental changes to improve an investor’s core exposure. For example, when comparing the John Hancock Multifactor Mid Cap ETF (NYSEArca: JHMM) to the benchmark Russell Midcap Index weights, JHMM is underweight large-caps and overweight mid-caps while also market weight growth and overweight value. The goal is to create a portfolio that tilts toward higher profitability compared to the benchmark Russell Midcap Index.
Michelle Fuller, Senior Managing Director, Head of ETF Distribution, John Hancock Investment Management, argued that the John Hancock Multifactor Mid Cap ETF can be a great core equity holding for broad mid-cap exposure to target a wide range of mid-cap U.S. stocks and access the breadth of the market’s opportunities. JHMM follows a times-tested multi-factor approach that emphasizing factors like small cap, lower relative price, and higher profitability, which academic research has linked to higher expected returns. Additionally, this traditionally active fund strategy comes in an efficient ETF wrapper to minimize turnover, trading costs, tax liabilities, and cash drag.
Investors will find that JHMM’s multi-factor approach has yielded strong returns and better risk-adjusted returns over the long haul. From October 2015 through June 2020, JHMM showed Sharpe ratio of 0.51, compared to the 0.37 for the S&P MidCap 400 Index and 0.34 for the Morningstar Mid-cap blend category.
Financial advisors who are interested in learning more about mid-cap strategies can watch the webcast here on demand.