Asset Allocation and Midcaps

Many asset-allocation models (including SmartMoney's) leave out midcap stocks. So where do my midcap funds belong?

QUESTION: Most Web site asset-allocation tools suggest a certain percentage of large caps and small caps, but midcaps are seldom mentioned. When creating an asset-allocation plan, should you treat midcap funds as large-cap funds, small-cap funds or 50% of each?

ANSWER:

Historically, midcap stocks have delivered the higher returns associated with small caps, gaining on average 11.63% a year from 1926 to 2000, according to the Center for Research in Security Prices. For that reason, some market thinkers, including the people we spoke with at Morningstar and several certified financial planners, believe midcaps are better grouped with small caps. At the same time, though, midcaps have delivered significantly less volatility than small caps, making them act more like their large-cap brethern.

If you're up to it, there are more complicated ways to incorporate midcaps into an asset allocator. You could, for example, consider the market cap of the midcap portfolios that you hold. Midcap funds with lower median market-cap sizes (say in the range of $1 billion to $5 billion) might be grouped with your small-cap investments, while "bigger" midcaps (from $5 billion to $10 billion) could be corralled with your large caps.

Now, if you're considering adding a midcap fund to your current portfolio, be sure to research the fund carefully. Many funds labeled as such actually hold stocks of all sizes, but their median market cap places them in the midcap arena. To find a true midcap portfolio, check the fund's prospectus to make sure midcaps are indeed its principal investment target.

An easy way to ensure that you have a true-blue midcap fund on your hands is to invest in a midcap index fund, as the S&P Midcap 400 Index and similar benchmarks are monitored closely and rebalanced regularly. Two low-cost choices are the California Investment S&P MidCap Index (SPMIX) and the Vanguard Mid Capitalization Index (VIMSX), with annual expenses of 0.40% and 0.25%, respectively. However, investors should consider holding such funds in tax-deferred accounts, since midcap stocks that outgrow the index must be sold, presenting potential tax problems for the funds.