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Why Don’t People Use Mid-Cap Funds?

A reader writes in, asking:

“I notice that in your ‘8 lazy ETF portfolios‘ article, there are exactly zero funds focused on mid caps, but several ETFs focusing on small caps are included in the various portfolios. I guess my question is… why is this? I’m seeking to weight my Vanguard Roth more heavily toward smaller domestic stocks, and I don’t quite understand the lack of interest in mid cap.”

When it comes to diversification within the stock portion of one’s portfolio, there are two schools of thought within the broader “passive investing” group of investors.

Diversification via Number of Stocks

One line of thinking is that, once you have an allocation to as many stocks as possible, you cannot get any more diversified. In other words, with regard to US stocks, a “total market” fund is as diversified as you can be, because it already includes the entire US stock market (or as close to it as possible). And ditto with a “total international” fund.

This is the line of thinking that Allan Roth, for example, is using with his “Second Grader Portfolio.” It’s also the line of thinking that Vanguard uses with their Target Retirement funds (which hold three underlying funds: Vanguard Total Stock Market, Vanguard Total International Stock, and Vanguard Total Bond).

Diversification via Risk Factors

Twenty years ago, researchers Eugene Fama and Kenneth French found that certain types of stocks (specifically, small-cap stocks and value stocks) perform noticeably differently than other stocks (specifically, they have higher returns, presumably due to higher risk).

The second school of thought within the broader “passive investing” school argues that additional diversification can be achieved by exposing one’s portfolio to a significant amount of small-cap risk and value risk in addition to normal stock market risk. And, naturally, the easiest way to do this is to add a fund all the way at the small-cap/value end of the spectrum rather than going only half-way down the spectrum with mid-cap funds.

Where Do Mid-Cap Funds Fit?

In other words, there’s nothing at all wrong with mid-cap funds (or, more broadly, with mid-cap stocks). They just don’t fit very neatly into either of the two major schools of thought. One school of thought thinks a total market fund is all you need. And the other school of thought, seeking to achieve small-cap exposure in the easiest way possible, goes directly to small-cap funds as a way to supplement a “total market” holding.

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  1. Mike, you write that according to one theory, “additional diversification can be achieved by exposing one’s portfolio to a significant amount of small-cap risk and value risk.” And I note that of the Lazy Portfolios, a couple of them are putting 25% or more towards small cap and/or value. My questions are, to achieve a diversification benefit, is there a minimum tilt towards sm/val, and would you need to do this both for domestic and international holdings? Personally I have only 3% in Vgd. Small Cap Value fund and 3% in the International Small Cap. Am I wasting this allocation space? And of the two “schools of thought,” which way do you lean?

  2. Larry,

    With regard to multi-risk-factor investing, I’m probably not the best person to ask, because I haven’t done any of my own actual research — I’ve just read what others have to say.

    From what I’ve seen, there doesn’t appear to be a great deal of consensus. The small/value allocations I’ve seen range from 25% of the stock allocation (including international) all the way up to 100% of the stock allocation.

    On the other hand, as I mentioned, there are plenty of people who simply don’t believe there is anything better about tilting.

    Personally, I could go either way. I’m perfectly happy to control the risk level of my portfolio using just the stock vs. bond lever, without touching the small vs. large or growth vs. value levers at all. But, for me, simplicity is of greater importance than it is for many investors. So if, for example, Vanguard’s all-in-one funds all included a small/value tilt, I would still probably be inclined to use one of them (as opposed to building a DIY-portfolio without a small/value tilt, that is).

    In other words, my own position is probably similar to that of Eugene Fama, as explained in a DFA interview [update: now removed from their website] (starting around 11:35).
    Interviewer: Some people cite your research showing that value and small firms have higher average returns over time and they assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

    Fama: Um, no. (Laughs) Basically this a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It’s always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes.

    But that’s what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn’t do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can’t argue with that either.

    So there’s a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can’t quarrel with. And I have no recommendations about because I think it’s totally a matter of taste. If you eat oranges and I eat apples I can’t really quarrel very much with that.

  3. Nice topic! Two comments after reading:

    1. This seems like a good place to remind people that owning a bazillion different stocks is different than diversification. Diversification is owing different stocks because they behave differently. Owning multiple stocks that behave the same isn’t diversification, nor is continuing to broaden your holdings after you’ve already achieved effective statistical diversification. In the low-expense, passive investing world you want to be diversified but you want to buy diversification as cheaply as possible. This is one of the underlying reasons why people don’t hold mid-caps: they are trying to build their portfolios out of the fewest number of building blocks, so they pick better representatives of the various “tilts”. Once they’re done, they find they are already statistically diversified – no need to add any more pieces. It doesn’t actually take many holdings to achieve all of the useful diversity you’re going to get, if they are in the proper relationship to one another.

    2. The blandness of mid-caps can be a boon that portfolio designers should keep in mind. Let’s say you want more value tilt but already have your small/large tilt dialed in. Just add a mid-cap value fund. Mid-caps can be expected to behave like a blend of small and large, and a mid-cap value fund is far more likely to maintain the balance you’re after than a generic value fund, whose tilt you’d have to gauge on your own.

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