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  • Home>Research & Insights>Investment Insights>A Top-Rated Choice for Diversified, Low-Cost Exposure to U.S. Mid-Caps

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    A Top-Rated Choice for Diversified, Low-Cost Exposure to U.S. Mid-Caps

    An ultralow fee gives this fund a sustainable edge relative to category peers.

    Ben Johnson, 12/09/2016

    IShares Core S&P Mid-Cap IJH offers diversified exposure to U.S. mid-cap stocks. A low fee and a soundly constructed, reasonably representative benchmark leave this exchange-traded fund well-positioned to continue its long streak of producing superior risk-adjusted returns relative to its peers over the long haul and underpin its Morningstar Analyst Rating of Gold.

    During the 10-year period ended Sept. 30, 2016, IJH returned 8.99% per year, outstripping the U.S. mid-blend Morningstar Category average by 2.2 percentage points per year. Much of this relative outperformance can be attributed to the fund's sizable fee advantage. At 0.07%, IJH's annual levy is a tiny fraction of the 0.97% median fee charged by its category peers.

    Broad diversification is an intrinsic advantage of funds tracking broad market-cap-weighted indexes. However, market-cap weighting has its pluses and minuses. It can be a beneficial approach in momentum-driven bull markets that are characterized by large-cap leadership, such as the post-financial-crisis charge in U.S. stocks. It can also lead to significant sector and single-security concentration, as witnessed at the height of the technology bubble. So market-cap-weighted indexes' greatest strength is arguably also their Achilles' heel.

    Low turnover is another key advantage of a fund tied to a market-cap-weighted benchmark. Lower turnover equates to lower transaction costs and a lesser likelihood of taxable capital gains distributions. IJH's median annual turnover was 14.0% during the trailing 10 years. This compares with a median figure of 77.3% for its category peers. 

    Fundamental View
    Each index provider defines mid-cap stocks slightly differently, but they generally account for around 7% to 20% of the total market capitalization of the U.S. market after the largest stocks, which make up about 70% to 80% of the market in aggregate. Morningstar defines mid-caps as the 20% of the market after the largest 70%, which roughly corresponds to the next-largest 600 or so stocks after the largest 300.

    Mid-cap stocks have been in the sweet spot of risk-adjusted performance since 1926. Although they have historically had a higher return than large caps, they have also had a higher volatility and a higher beta, or more procyclical movement with the market. But the higher return has compensated investors for the increased risk. While small caps had even higher returns, mid-caps have had a slightly better ratio of return to risk. For this reason, many investors chose to give an overweighting to mid-cap stocks. Yet there is no guarantee their past outperformance will persist. 

    The outperformance of mid-cap stocks during the past 15 years has caused them to look expensive relative to large-cap stocks. As of October 2016, this fund's mid-cap stocks were trading at a price/prospective earnings ratio of 20.2 while the less-volatile large caps in the S&P 500 were trading at a more reasonable 19.0. The dividend yield on stocks on mid-caps is about 1.8% versus about 2.3% for the S&P 500.

    The valuation premium of mid-cap stocks could be justified in part based on analyst expectations for faster earnings growth. According to consensus analyst estimates, earnings for the stocks in the fund are expected to grow at 10.2% during the next three to five years, compared with 8.5% for stocks in the Russell 1000. An investment in mid-cap stocks may give investors access to a faster-growing segment of the market without as much volatility as small caps. Mid-cap stocks may be attractive acquisition targets for large companies. Particularly in this environment of slower economic growth, large companies may look to acquire smaller companies to fuel growth.

    Ben Johnson is Morningstar’s Director of European ETF Research.