This Day On The Street
Continue to site right-arrow
ADVERTISEMENT
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here
TheStreet Open House

How Size Factors Into Your Fund Strategy

Volatility and return are two factors every investor should keep an eye on. If the goal is to maximize return, you must, of course, expose your portfolio to some amount of volatility. But how do you determine the proper amount?

Several years ago, I worked briefly for Fisher Investments. During my time there, I learned a lot about how one part of the market can serve as a proxy for another. I also came to see that in many ways, a diversified portfolio is simply a blend of different ingredients designed to create the desired portfolio characteristics and returns.



I discussed this proxy relationship in noting that the First Trust IPOX 100 (FPX) might be a good way to capture small-cap growth.

Fisher Investment research shows that mid-cap stocks can serve as a less volatile proxy for small-cap stocks. To investigate this scenario, let's take a look at some domestic and foreign exchange-traded funds, two mid-caps and two small-caps.

Domestic Exposure

The Mid-Cap SPDR Trust (MDY) and the iShares Russell 2000 Index Fund (IWM) are the most active mid-cap and small-cap ETFs, respectively. MDY's holdings have an average market cap of $2.75 billion, while IWM's average cap size is $641 million.

According to PortfolioScience.com, the two ETFs have a correlation of 0.947, which is very high considering 1.00 is considered a perfect match. IWM is noticeably more volatile, with a standard deviation (a statistical measure of risk) of 17.98. In comparison, MDY has a standard deviation of 14.24. The beta numbers for the ETFs tell a similar story, with MDY at 1.211 and IWM at 1.52. A fund with a beta greater than 1 is considered more volatile than the market; less than 1 means less volatile.

For comparison, the S&P 500 SPDR (SPY) has a standard deviation of 10.58 and a beta of 0.97.

What the above figures tell us is that for the last year at least -- which is as far back as PortfolioScience.com data go -- there is indeed something to the thesis that investors can realize a good rate of return with less volatility by intelligently monitoring the average market cap of their portfolios and using mid-caps as a proxy for small-caps. And after all, most money managers out there regularly preach the wisdom of capturing good returns while lowering volatility.

And by adding a few small-cap stocks or a small-cap fund to the mix, an investor can bring down the average cap size of his or her portfolio without taking on all of the risk associated with a portfolio invested solely in small-caps. (You can use morningstar.com to calculate the average cap size of your portfolio.)

How does this theory stand up in the real world? The chart below shows that the Mid-Cap SPDR Trust and the Shares Russell 2000 Index Fund move very closely together, with the occasional bit of lag or lead from the Russell index.

Close Correlation
A Mid-Cap and a Small-Cap Find Common Ground

Foreign Figures

What about foreign ETFs? The only funds that broadly isolate foreign stocks by cap size are the WisdomTree International Mid-Cap Dividend Index (DIM) and the WisdomTree International Small-Cap Dividend Index (DLS).

These two ETFs have been trading only since June of this year, so our conclusion needs to take that into consideration. That said, DIM has a higher standard deviation -- 14.64 -- and higher beta -- 0.80 -- than the small-cap ETF, which has a standard deviation of 13.23 and a beta of 0.68.

Foreign Affairs
The Mid-Cap Is the Clear Winner Thus Far

As the chart shows, the WisdomTree mid-cap ETF has dramatically outperformed the small-cap fund since inception. (Again, the two WisdomTree funds began trading in June 2006.)

So, what have we learned from these small-cap and mid-cap analyses? Simply stated, there are two ways for you to use the conclusions. The extreme approach would be to never buy a small-cap fund and stick with mid-cap funds only. I think, though, that monitoring the average cap size of your portfolio, and adjusting it when necessary, is the better way of improving your chances of achieving market-beating returns with less volatility. It is likely unwise to hold small-cap funds or stocks alone, but adding them to a broader portfolio is an ideal way to increase your return potential while keeping risk under control.

P/>Roger Nusbaum is a portfolio manager with Your Source Financial of Phoenix, Ariz., and the author of Random Roger's Big Picture Blog. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Nusbaum appreciates your feedback; click here to send him an email.

Select the service that is right for you!

COMPARE ALL SERVICES
Action Alerts PLUS
Try it NOW

Jim Cramer and Stephanie Link actively manage a real portfolio and reveal their money management tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
  • Weekly roundups
TheStreet Quant Ratings
Try it NOW
Only $49.95/yr

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
  • Upgrade/downgrade alerts
Stocks Under $10
Try it NOW

David Peltier, uncovers low dollar stocks with extraordinary upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
  • Weekly roundups
Dividend Stock Advisor
Try it NOW

Jim Cramer's protege, David Peltier, identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Alerts when market news affect the portfolio
  • Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
Real Money Pro
Try it NOW

All of Real Money, plus 15 more of Wall Street's sharpest minds delivering actionable trading ideas, a comprehensive look at the market, and fundamental and technical analysis.

Product Features:
  • Real Money + Doug Kass Plus 15 more Wall Street Pros
  • Intraday commentary & news
  • Ultra-actionable trading ideas
Options Profits
Try it NOW

Our options trading pros provide daily market commentary and over 100 monthly option trading ideas and strategies to help you become a well-seasoned trader.

Product Features:
  • 100+ monthly options trading ideas
  • Actionable options commentary & news
  • Real-time trading community
  • Options TV
To begin commenting right away, you can log in below using your Disqus, Facebook, Twitter, OpenID or Yahoo login credentials. Alternatively, you can post a comment as a "guest" just by entering an email address. Your use of the commenting tool is subject to multiple terms of service/use and privacy policies - see here for more details.
Submit an article to us!
DOW 16,719.74 +41.84 0.25%
S&P 500 1,952.68 +1.86 0.10%
NASDAQ 4,460.0170 +7.2250 0.16%

Brokerage Partners

Rates from Bankrate.com

  • Mortgage
  • Credit Cards
  • Auto

Free Newsletters from TheStreet

My Subscriptions:

After the Bell

Before the Bell

Booyah! Newsletter

Midday Bell

TheStreet Top 10 Stories

Winners & Losers

Register for Newsletters
Top Rated Stocks Top Rated Funds Top Rated ETFs