(PUB) Investing 2016

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12 • Fund Family Shareholder Association
in a company with a market cap of $2
billion. (Remember, market cap is a
measure of a company’s size, and is
calculated by multiplying the stock’s
price by the number of shares outstand-
ing.) The first fund—let’s call it Small
Fund—has $2 billion in assets, while
the second fund, Large Fund, has $10
billion. If the manager of Small Fund
wants to establish a meaningful 2%
position, she would buy $40 million
of the company’s stock, or 2% of all
shares outstanding. If the manager of
Large Fund buys the same $40 million
of the company’s stock, the resulting
position will only be 0.4%—not exactly
moving the needle. For Large Fund to
hold the same 2% position, the manager
has to buy $200 million of the com-
pany’s stock, or 10% of the company.
That’s why it becomes increasingly
harder to buy and sell small- and mid-
sized stocks as fund assets expand.
One way to defend against asset levels
growing too big for the strategy (some-
times referred to as asset bloat) is to
close the fund—but even this may not
be enough.
For years, Capital Opportunity
was the single best aggressive small-/
mid-cap fund Vanguard offered, and if
you’ve followed Dan’s and my advice
to buy and hold this PRIMECAP-
managed fund, you’ve reaped the
rewards. But as we’ve discussed in the
past, its increase in assets means that
while still a great fund, it is no longer a
great smid-cap fund.
Yes, Vanguard has on occasion
closed funds, but the preferred solution
seems to be to just add another man-
ager to the portfolio. Doing so keeps
any single manager from having too
many dollars to invest, but it comes at a
cost: The portfolio and performance get
watered down and begin to look like the
index. Think of Explorer and the seven
different management firms stirring its
pot. It’s going to be difficult to serve
up an appetizing meal with that many
chefs in the kitchen.
Maybe Vanguard’s recent moves to
slim the manager ranks at Explorer
Value and International Growth indi-
cate a lasting change in the firm’s
approach to the multimanager strategy?
I hope so. The combination of ever-
larger funds and Vanguard’s misguided
commitment to the multimanager for-
mat are why I suggest that investors
looking for some pop from their stock
funds and unwilling to look outside the
Vanguard fold may find an index fund
to be their best option.
A Market Sweet Spot
All is not lost. Investing in some
of these aggressive funds can still
yield decent rewards, and in a minute,
I’ll sort out the active and passive
funds in this group in more detail.
But first, let’s take a closer look at
mid-cap stocks, because if there is a
sweet spot in the market for portfo-
lio growth, mid-sized companies fit
the bill. Many mid-sized companies
exhibit the growth characteristics of
small companies and the financial sta-
bility of large ones, yet they are often
overlooked by investors.
Why? Well, the largest publicly
traded companies garner the attention
of Wall Street banks because of the
hefty investment banking fees they
pay on stock offerings, bond issuance,
advice on mergers and acquisitions,
etc. The media focuses its attention
on the large “household name” com-
panies, because it makes their sto-
ries relevant to the listeners’ lives. At
the same time, smaller companies,
with their higher risks and higher
potential returns, grab the attention
of risk-takers and provide the sizzle
of sometimes daily double-digit gains
and losses. It’s the middle ground, like
the proverbial middle child, that gets
ignored.
As a result, investors may be missing
a wonderful opportunity, considering
that long-term mid-cap index returns
tell a pretty bullish story. The chart to
the left of the relative performance of
various Russell indexes over the 37
years they’ve been calculated shows
that over the long run, mid-cap stocks
have outpaced both their larger and
smaller siblings. The blue line com-
pares the Russell Midcap Index and
the large-cap Russell Top 200 Index.
When it is rising, mid-cap stocks are
outperforming large-caps. The black
line compares the mid-cap index to
the small-cap Russell 2000 Index, and
again, it rises when mid-caps outper-
form.
To put some numbers behind the
chart, over more than three decades, the
Russell MidCap index returned 13.2%
a year—about 2% better per annum
than both the large-cap Russell Top
200 and the small-cap Russell 2000
indexes. A 2% annual advantage may
not seem like much, but it really adds
up over time.
One hundred dollars invested in the
Russell Midcap Index at the end of
1978 would have grown to $10,501
by the end of July 2016. Meanwhile, a
similar investment in large-cap stocks
(Russell Top 200 Index) would have
grown half as much, to just $5,239. And
small-cap stocks, as measured by the
Russell 2000 Index, would have turned
that $100 into $5,385.
As the chart shows, this return edge
is not the result of one outstanding
period, as mid-caps held their advan-
tage in many different environments
and cycles.
An investment rule of thumb is that
with higher returns comes higher risk,
but mid-cap stocks turn that chestnut
upside down. The table on page 13
shows the maximum cumulative loss
(or drawdown) and the time it took to
recover from the losses for the Russell
indexes during the four big bear mar-
kets of the past 37 years. The Russell
Midcap Index’s steepest decline—
a loss of 54.2% reached during the
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Mid-Sized Companies,
Outsized Returns
7/807/837/867/897/927/957/987/017/047/077/107/137/16
0.75
1.00
1.25
1.50
1.75
2.00
2.25
Mid-Cap/Large-Cap
Mid-Cap/Small-Cap