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.
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.
A Mid-Cap and a Small-Cap Find Common Ground
Foreign FiguresWhat 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.
The Mid-Cap Is the Clear Winner Thus Far
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