1. Meridian Growth Fund MERDX

2. Nicholas Equity Income Fund NSEIX

3. Waddell & Reed Adv New Concepts UNEYX

4. Ivy Mid Cap Growth I IYMIX

5. Westport Fund WPFRX

One of the first lessons anyone learns in a course on finance and markets is that there is no such thing as a free lunch. There is the tale of the economics professor walking across campus with a student. The student notices a $20 bill lying on the ground and points it out to the professor. “Nonsense” replies the professor, waving him off, “markets are efficient, so someone would have already picked it up, and therefore it can’t be there”.

One might be inclined to substitute “Mid Cap Stocks” for the $20 bill of the old tale. Consider the following table:

Mid cap stocks have outperformed both large cap and small cap stocks with surprising consistency over multiple time periods in the last 15 years, and the strong performance continues through this year. What is it about this sector that makes it such a consistent winner? In fact, this kind of analysis seems to thoroughly fly in the face of the “rational economics” of college textbooks and their real-world corollary, efficient markets. If you can outperform the market simply by allocating more weight to a particular style (like mid cap) then the rest of the market should pick up on this opportunity and pile in – arbitraging away the advantage and in effect picking up the $20 bill. But style effects have been shown in other analyses as well – the “value effect” has shown a similar trend for value stocks relative to growth stocks over multiple periods.

The “mid cap effect” may be transitory. Perhaps it has to do with the fact that most of the large financial institutions that were battered during the 2008-09 market crash were among the largest of large cap stocks, such that large caps took the brunt of that painful period. If that were the case then we would expect to see the mid cap advantage fade away as those crash years fade into history. On the other hand, mid caps do seem to merit consideration as a portfolio addition.

Irina Smirnova

Our Jem5 investor this week is Irina Smirnova. Irina studied economics at Moscow State University during the perestroika era leading into the demise of the Soviet Union, during which time she became fascinated with the concepts of market economics. She came to the University of Chicago to pursue graduate work in the theory of financial markets, no doubt spending much time in the company of professors who would resolutely deny the possibility of random $20 bills lying around campus. But after graduation Irina joined a financial advisory firm in Chicago, earned her CFA® charter and came face to face with these anomalous style effects – value versus growth, capitalization and so on. Recently she has been following the mid cap sector with some interest. Irina decides that a little mid cap exposure can’t hurt, and sets up a Jem5 profile against which to rank the best mid-cap funds for her.

Comments: Not surprisingly, given the strong multi-year performance of mid cap stocks, the top funds in this category show strong overall Jemscores. In fact they all show strong returns in the short, medium and long term with risk levels (as measured by standard deviation) largely in line with the Vanguard index fund. The fee structures are competitive as well – the top two funds have expense ratios below 1%, which is sort of an informal benchmark we use for many categories of actively managed US equities funds.

Irina did not specify a growth versus value preference in setting up the Jem5 profile, but she notices that at least two of the funds have a growth orientation (the Waddell & Reed fund also appears to be somewhat more inclined towards the growth side of the market). She wonders if she should be careful here, and opt for more neutral territory rather than taking a second style bet on top of the mid cap focus. She considers this for awhile, and eventually decides to go with the #2 fund, Nicholas Equity Income, which is fairly value/growth-neutral and also has the best Risk/Return Jemscore.

*Note: Jem 5 is a regular feature on the Jemstep blog which represents our top mutual fund ratings for unique investor profiles. For more information, read our first post in the series.

TAGS: jem5, mid-cap funds, mutual fund analysis