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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.


discussed this proxy relationship in noting that the

First Trust IPOX 100

(FPX) - Get First Trust US Equity Opportunities ETF Report

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


Mid-Cap SPDR Trust

(MDY) - Get SPDR S&P Midcap 400 ETF Trust Report

and the

iShares Russell 2000 Index Fund

(IWM) - Get iShares Russell 2000 ETF Report

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, 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.

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For comparison, the

S&P 500 SPDR

(SPY) - Get SPDR S&P 500 ETF Trust Report

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 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 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) - Get WisdomTree International MidCap Dividend Fund Report

and the

WisdomTree International Small-Cap Dividend Index

(DLS) - Get WisdomTree International SmallCap Dividend Fund Report


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;

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