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A distinct allocation to mid-caps should be a part of any strategic or tactical asset allocation mix.
Avoiding mid-cap stocks has the potential to impact portfolios negatively.
With such strong performance, both on an absolute and risk adjusted basis over the last 25 years as documented in my recent white paper, the impact of not allocating to mid caps can be a negative to portfolios—for both strategic as well as tactical strategies.
A naive historical blend of a large-and small-cap allocations relative to a balanced large, mid, and small blend reinforces one aspect of this argument. Two portfolio blends were created using the current weights of the S&P Total Market Index (TMI), a measure of over 3,000 stocks, based upon S&P’s criteria for a mid-cap stock. One portfolio was created where the 9% current TMI allocation to mid-cap stocks was absorbed by the large-cap exposure and the other where each cap spectrum was held at the exact weights (87%, 9% and 4%). These weights will differ from the historical weights at each interval, but still provide a strong proxy for reflecting the impact due to the avoidance of mid-caps in the asset allocation framework.
As shown below, these minor tweaks to portfolio weights led to slight improvements in risk-adjusted returns over many of the timeframes—as would be expected based on the individual market-cap style return profiles depicted in my aforementioned white paper. Larger adjustments to the percentage of mid caps may result in larger impacts.
The analysis above depicts a strategic allocation with minor weight adjustments. Leveraging the rules-based techniques from Gary Antonacci’s Dual Momentum1 framework also reveals that avoiding mid-caps can have detrimental impacts to tactical strategy performance. The rules governing a Dual Momentum strategy consist of two steps:
Step 1: Calculate Relative Momentum among a mix of assets and pick the asset with the highest relative performance over the past 12 months.
Step 2: Calculate Time Series Momentum for the asset with the strongest relative momentum by examining the total return of that asset relative to the return on Treasury Bills.
If the excess return of the asset from step 2 is above zero, then the rule suggests going long the asset. Otherwise it suggests allocating to Treasury Bills.
This rules-based framework was applied to a mix of assets consisting of large caps, mid caps, small caps, and T-bills as well as a mix of large caps, small caps, and T-Bills—excluding the presence of mid caps. Both asset mixes were rebalanced monthly and do not assume any transaction costs.
The cumulative return performance is plotted below for the two Dual Momentum blends (one with mid-caps and one without) as well as versus the broad-based market cap weighted Russell 3000 Index.
Source: FactSet as of July 31, 2019, based on return information from 9/1995 to 7/2019. Past performance is not a guarantee of future results. Large-caps: S&P 500, Mid-Caps: S&P 400, Small-Caps: Russell 2000 Indexes, T-Bills: Bloomberg Barclays US Treasury Bill Index. Index returns are unmanaged and do not reflect the deduction of any fees or expenses. Index returns reflect all items of income, gain and loss and the reinvestment of dividends and other income.
Given the performance trends documented in the white paper, the Dual Momentum mix of assets with mid caps included had the stronger performance. Beyond the cumulative outperformance since 1995 (879% vs. 772%), additional metrics underscore the potential power of the middle, as shown below. The Dual Momentum with mid caps not only had higher returns, but also higher Sharpe and Sortino ratios and lesser drawdowns.
Understanding the appropriate allocation to mid-cap equities within a broader asset allocation framework will depend on the individual investors risk and return profile. Investor preference notwithstanding, a distinct allocation to mid-caps should be a part of any strategic or tactical asset allocation mix, as the above basic examples show that the effects of avoiding the middle can potentially negatively impact portfolios.
1 Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk, Gary Antonacci October, 2014
Investments in mid-sized companies may involve greater risks than those in larger, better known companies, but may be less volatile than investments in smaller companies.Index returns are unmanaged and do not reflect the deduction of any fees or expenses.
Index returns reflect capital gains andlosses, income and the reinvestment of dividends. You cannot invest directly in an index.
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