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ETF Specialist

This ETF Targets an Overlooked Segment of the Market

Large- and small-cap companies are only part of the equation.

Diversification is one of the most powerful tools an investor has to manage risk. Yet, when it comes to their U.S. equity allocations, investors are often underexposed to mid-cap stocks. Low-cost indexing is a powerful way for investors to gain access to this segment of the market, and Schwab U.S. Mid-Cap ETF (SCHM) is an outstanding fund in this asset class. As one of the cheapest and most broadly diversified market-cap-weighted funds in the category, it earns a Morningstar Analyst Rating of Gold.

This fund tracks the Dow Jones U.S. Mid Cap Total Stock Market Index, which offers broad, market-cap-weighted exposure to U.S. mid-cap stocks. The resulting portfolio accurately represents the composition of the U.S. mid-cap market segment. Its sector exposures are similar to the mid-cap blend Morningstar Category average, as is its market-cap orientation.

Market-cap weighting reflects the market's collective wisdom. Market prices tend to do a good job reflecting information that's available to the public, making it hard to beat the market, especially over long term. However, over shorter periods, investors may overreact and either drive prices too high or low. Market-cap weighting will increase or decrease exposure to stocks accordingly. That said, the fund's broad diversification and low-cost advantage far outweigh this minor disadvantage.

The portfolio holds about 500 stocks, similar to the category average. The top 10 positions represent about 5% of assets. This effectively diversifies firm-specific risk.

Schwab charges an ultralow 0.04% fee for this fund. This cost advantage has translated into strong category-relative performance over the long term. From its inception in January 2011 through July 2019, the fund has outperformed the category average by 270 basis points annualized while exhibiting slightly greater risk. On a risk-adjusted basis, the fund outperformed the mid-blend category average. Overall, this fund should continue to enjoy a durable long-term edge over many of its competitors thanks to its  low expense ratio and lower-than-average cash drag.

Fundamental View
Mid-cap stocks tend to have higher long-term growth potential than large-cap stocks. This is evidenced by the Dow Jones U.S. Total Stock Market Mid Cap Index's higher earnings growth compared with the Dow Jones U.S. Total Stock Market Large Cap Index over the trailing five years through July 2019. Furthermore, mid-cap stocks exhibit less volatility than small-cap stocks. Over the trailing five years through July 2019, the Dow Jones U.S. Total Stock Market Mid Cap Index's annualized standard deviation of returns was 13.6% versus 15.7% for the Dow Jones U.S. Total Stock Market Small Cap Index.

In addition to harnessing the market's collective wisdom, this broad market-cap weighted portfolio mitigates turnover, which helps minimize transaction costs and makes the index easier to track. By being fully invested, it has a minimal cash drag, which helps its category-relative performance during bull markets, although this can hurt in bear markets.

Indexing in mid-caps presents a unique advantage. Although there is potential for sector concentration, the risk of stock-specific concentration is significantly mitigated by the fact that companies that become too large will graduate out of the mid-cap index and into the large-cap index. Additionally, companies that experience a significant decline in market cap may drop out of the mid-cap index. With the top five holdings (Veeva Systems (VEEV), Cadence Design Systems (CDNS), Teleflex (TFX), Arthur J. Gallagher & Co. (AJG), and Amcor PLC (AMCCF)) accounting for only 2.9% of the portfolio, the fund is well-diversified and provides broad exposure to mid-caps at a low cost.

The fund does not constrain sector allocation, and this may lead to overallocation to sectors as they become more richly valued and have lower expected returns. As a result, the fund may be overexposed to cyclical sectors like financial services and consumer cyclicals and sensitive sectors such as industrials and technology and underexposed to defensive sectors such as utilities. Cyclical sectors tend to be correlated with the overall economy, which presents a macroeconomic risk, while defensive sectors are somewhat immune to this effect. However, the fund's sector exposures are similar to the category average.

From its inception in January 2011 through July 2019, the fund has outperformed the category average by 270 basis points annualized while assuming slightly higher risk. On a risk-adjusted basis, it also outperformed the category average. Much of this relative outperformance can be attributed to the fund's cost advantage, lower-than-average cash drag, and poor stock selection among the fund's active peers. 

Portfolio Construction
The fund employs full replication to track the market-cap-weighted Dow Jones U.S. Total Stock Market Mid-Cap Index. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting its Positive Process Pillar rating.

The Dow Jones U.S. Total Stock Market Mid-Cap Index ranks U.S. stocks by market cap, excludes the largest 600 stocks, and targets the next largest 500. When the index reconstitutes each year in September, current holdings that rank between the largest 401st and 1,100th by market cap are included first to reduce unnecessary turnover. Like most index peers, the fund adjusts its holdings' weightings to reflect free-float market cap.

New stocks added to the index must meet a minimum trading volume threshold to be included.

The fund carries a low fee of 0.04%, a fraction of the 0.96% median levy its mid-blend category peers charge. It earns a Positive Price Pillar rating. During the trailing five years through July 2019, the fund lagged its benchmark by 3 basis points per year, slightly less than the amount of its fee. This implies the fund has been able to offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Investors seeking alternatives to SCHM have several options, including Gold-rated Vanguard Mid-Cap ETF (VO) (0.04% expense ratio), Gold-rated iShares Core S&P Mid-Cap ETF (IJH) (0.07%), Silver-rated SPDR S&P MidCap 400 ETF (MDY) (0.24%), and Gold-rated Vanguard Extended Market ETF (VXF) (0.07%).

Similar to SCHM, VO tracks an index that is designed to minimize transaction costs. It applies generous buffers to mitigate unnecessary turnover. And like SCHM, VO charges a low 0.04% expense ratio.

IJH tracks the S&P MidCap 400 Index, which is maintained by a committee that has some discretion in the portfolio construction process. While stocks must have a market caps between $2.4 billion and $8.2 billion, size is not the only consideration. The index holds 400 stocks that are representative of the mid-cap segment. IJH charges a low expense ratio of 0.07%, similar to its Gold-rated peers.

VXF tracks the S&P Completion Index, a broad market-cap-weighted index that represents nearly every U.S. stock outside of the S&P 500. The fund is intended to complement S&P 500 holdings. It reduces transaction costs by sampling among the smallest, least liquid stocks, but it still holds nearly every stock in the index.


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Venkata Sai Uppaluri does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.