Managers and consultants hash out the category’s strengths and weaknesses. Some asset managers are keen to see the mid-cap category shed its “middle child” status and start getting the attention they think it deserves. They argue it offers a big chunk of small cap’s return potential with lower volatility. And though that message seems to be getting through to institutional investors, some private-client consultants say mid-cap holdings are worrisome from a tax perspective and contribute too little in terms of diversification.

On the face of it, mid cap – which refers to stock in companies with market capitalizations of between $1.5 billion and $10 billion – doesn’t seem to suffer from neglect. As of 31 May 2005, mid-cap mutual-fund allocations came to $442 billion versus $2.3 trillion in large cap and $372 billion in small cap, according to data from Morningstar, a Chicago-based financial information and technology provider.

Institutional

Mid cap owes its middle-child status not to poor flows, but, in part at least, to the simple fact it hasn’t been tracked as long as large cap and small cap, says Todd Dalaska of Driehaus Capital Management, a Chicago-based separate account and mutual-fund manager. The S&P Mid Cap 400 Index is only about 15 years old compared with a 50-year track record for the Russell 2000 small-cap index and the S&P 500’s 79-year history of tracking large-cap stock performance.

Despite that, says Richard Zipkis of Granite Group Advisors, a Purchase, N.Y.-based investment consultancy to private and institutional clients, mid cap “has become fairly commonplace” in the last four or five years.

But if mid cap has become a mainstream category, it gets that status by virtue of its popularity with institutional investors, says Douglas Rogers, a Lake Barrington, Ill.-based managing director of CTC Consulting. Many private investors, meanwhile, steer well clear of it – and for good reason, he adds. “Mid cap is fine for pensions,” says Rogers, whose firm provides investment consulting to high-net-worth families and private foundations. “But it doesn’t make sense in a taxable account.” The problem, he says, is that mid-cap allocations bring more managers into play, and the more managers there are, the greater the chances of having to buy and sell issues to conform with each manager’s model. That comes at a cost to the private investor, making mid cap the preserve, says Rogers, of “non-taxable and uninformed taxable” investors.

Jim Blachman, CIO of Advisor Partners, a San Francisco-based indexed investment provider, wouldn’t go that far, but he notes that the potential for issue “migration” is especially high in the mid-cap realm because “it has two borders; two directions the stocks can go, not just one.”

Studies

Dalaska, who heads Driehaus’ outreach to family offices and high-net-worth advisors, agrees that “for some taxable accounts” there’s merit in limiting or simplifying allocations. “However, we believe tax-exempt or tax-deferred accounts benefit from the diversification, risk reduction and excess returns of mid cap.”

To support his point about risk reduction, Dalaska cites a University of Chicago study that suggests mid-cap investments yield about 85% of the returns associated with small-cap investments with about 40% of the volatility.

He illustrates the excess-return potential of mid cap with some in-house research. Driehaus figures that a dollar invested in 1986 and allocated 50% to T-bills and 50% to long-term government bonds would have yielded $3.40 by 2004. “You’d be lucky to keep pace with inflation,” says Dalaska. With 33% in T-bills, 33% in long-term bonds and 33% in a passive large-cap stock allocation, that dollar invested in 1986 becomes $4.70 by 2004: “You equal or beat inflation,” comments Dalaska. Pare down the fixed-income allocations to 25% each of T-bills and long-term bonds and give the other half over to passive large-cap, and that dollar grows to $5.40. Shave the fixed-income allocations back another 5% each to 20%, allocate 45% to passive large-cap and invest 15%, passively, in mid-cap stocks, and the dollar becomes $6.10. Finally, take those same allocations but replace the 15% earmarked for passive mid cap with Driehaus’ active mid-cap growth management, and a dollar put to work in 1986 becomes $7.60 by 2004.

In addition to managing $700 million in mid-cap growth, Driehaus manages $101 million in mid-cap recovery growth, which seeks to “maximize capital appreciation by investing in a diversified portfolio of U.S. traded, mid-cap stocks that are trading 30% or more off their highs,” according to the firm.

Worth a look

Advisor Partners’ Blachman has mixed feelings about mid cap. As a passive-core portfolio provider with a strategic approach to investing, his firm doesn’t allocate to that category. “It’s a hybrid with characteristics of large cap and small cap; some would even say it’s an artificial [category],” he says. But he sees value in an active approach to mid cap from a tactical viewpoint.

“Large-cap stocks did very well” in the 1990s because the companies they represent spent money on “expensive technologies that took a lot of cost out of their processes,” says Blachman. In recent years, however, technology vendors have been bringing similar efficiencies down market, giving smaller companies the opportunity to grow their margins. Blachman says that if he were a stock picker – and he isn’t one, he emphasizes – he’d look hard at mid-cap companies that have recently made substantial capital improvements along those lines.

Granite Group’s Zipkis likes mid cap for another reason. He sees promise in a category populated by solid, well-capitalized companies with good organic-growth potential that are also big enough to make acquisitions.

William Hummer of Wayne Hummer, a Chicago-based asset- and wealth-management subsidiary of Lake Forest, Ill.-based Wintrust Financial, says that every investor should be aware of mid cap’s characteristics, positive and negative – though he’s adamant that the good in them outweighs the bad. “It deserves consideration,” he says. “Nobody is talking about loading up on it, but the principal of diversification should apply to allocation as well as selection.” –FWR

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