As mid-cap funds go, this one is an odd duck, but it earns top marks.
As mid-cap funds go, Vanguard Extended Market ETF VXF is an odd one. The S&P Completion Index that this fund follows is an amalgamation of two groups of stocks: all of the large-cap U.S. stocks that do not meet the inclusion rules of the S&P 500 and all of the mid-, small-, and micro-cap stocks that are too small for that index. In other words, it holds nearly all U.S. stocks--about 3,300 in total--that are not constituents of the S&P 500. As such, it skews much further down the market-cap spectrum than do others in its cohort. Peculiarity aside, the fund's benchmark is reasonably representative, and its fee is low. These two factors leave VXF 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, VXF returned 8.27% per year, outstripping the U.S. mid-blend Morningstar Category average by 1.48 percentage points per year. Much of this relative outperformance can be attributed to the fund's sizable fee advantage. At 0.09%, VXF's annual levy is a tiny fraction of the 0.97% median fee charged by its category peers.
This is not a typical mid-blend fund. Its larger exposure to micro-cap stocks brings the average market cap of the fund down to near small-cap territory. Smaller-cap stocks tend to be more volatile than large caps because they generally are less profitable and are less likely to enjoy competitive advantages. Their greater sensitivity to macroeconomic risks means that small caps are likely to underperform during market downturns. Both of these factors drive volatility higher than the typical mid-blend fund. The volatility of return on the S&P Completion Index as measured by standard deviation was nearly 4 percentage points higher than that of the S&P 500 during the past decade. Despite these risks, the fund still has an above-average level of return per unit of risk versus its peers over the long haul.
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 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. Given this fund's unique benchmark, it has a materially lower average market cap relative to its peers and plots at the low end of the mid-blend section of the Morningstar Style Box.
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.
Small-cap stocks, which make up more than a third of VXF's portfolio, have earned a return premium of about 2% over large-cap stocks since 1926. However, this premium can vary drastically over time and has become smaller in recent decades. From 1979 through October 2016, the large-cap Russell 1000 Index outpaced the small-cap Russell 2000 Index. During the entire decade of the 1990s, small-cap stocks underperformed large caps by 3% per year. While the small-cap premium may be unreliable, it has been positive during the past 15-plus years, as small-cap stocks have been on a tear since the tech bubble burst. This stretch of outperformance has caused small caps to look expensive relative to large caps.
In the late 1990s, large caps traded at a premium relative to mid- and small caps. But this situation has reversed, and mid- and small-cap stocks now command premium valuations. As of October 2016, the stocks in this fund's portfolio were trading at a price/prospective earnings ratio of 20.4, while the less-volatile large caps in the S&P 500 were trading at a more reasonable 19.0. The dividend yield on stocks in VXF's portfolio was about 1.7% versus about 2.3% for the S&P 500.
Mid- and small-cap stocks often lack economic moats, or sustainable competitive advantages. Consequently, they tend to be less profitable and less resilient in the face of economic turbulence. Morningstar equity analysts rate fewer mid- and small-cap stocks, but of those they do rate that are included in VXF’s portfolio, just 10.6% of the assets have wide Morningstar Economic Moat Ratings, compared with 49.2% for rated large-cap stocks in the S&P 500. Furthermore, stocks in the S&P 500 generated an average return on invested capital of 12% during the past year; the corresponding figure for those in VXF's portfolio was 0.9%.