A Smart Beta Mid-Cap ETF Opportunity
This article was originally published on ETFTrends.com.
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.
"Since it is impossible to identify which factor will perform well based on where we are in the business cycle, hiring a manager that has exposure to multiple factors will help reduce volatility and provide more consistent return stream for the client. Put another way, we hope to help improve our odds with multifactor ETFs," Schneider added.
To help investors gain exposure to the mid-cap category, the John Hancock Multifactor Mid Cap ETF (JHMM) , which tracks a factor-based index developed by Dimensional Fund Advisors, follows a rules-based selection process that is seen as a multi-factor approach, combining a number of factors in a single portfolio to help investors gained improved risk-adjusted exposure to the mid-cap market segment.
The smart beta ETF’s underlying index adjusts security weights by relative price and profitability. The underlying index may overweight stocks with lower relative prices and underweight names with higher relative prices. The index can also adjust for profitability by overweighting stocks with higher profitability and underweighting those with lower profitability.
"Passively managed ETF seeks to improve on cap-weighted strategies by tracking a custom index that combines active management insight with the discipline of a rules-based approach," Michelle Fuller, Head of ETF Distribution for John Hancock Investments, said.
Fuller also explained that while investors may find these types of factor styles in actively managed funds, most active managers have historically underperformed their respective benchmarks, especially the mid-cap category.
"Mid blend has historically been one of the more difficult benchmarks to beat," Fuller said. "When you look at rolling 10 year returns over the past 20 years, mid blend has had the lowest percent of funds outperforming the category benchmark at 25%."
Financial advisors who are interested in learning more about the middle capitalization category can watch the webcast here on demand.
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