Growth Is in the Eye of the Index Provider
Many clients have been asking us this year about U.S. mid-caps. Over WisdomTree’s live history extending back to 2006 for mid-cap dividends and 2007 for mid-cap earnings, the performance of U.S. mid-caps has been robust, as discussed below. However, for those looking at 2017, the picture hasn’t been nearly as strong.
What, if anything, has changed?
Growth Style Comes into Favor—Heavily
“Growth” has been the way to go in the first nine months of 2017.
WisdomTree’s U.S. MidCap Dividend Index, though broad-based, won’t include any companies that don’t pay regular dividends, thereby biasing away from the growth style. WisdomTree’s U.S. MidCap Earnings Index, though broader, won’t include speculative firms that have not yet generated positive core earnings. In other words, both of these Indexes have somewhat of a quality bias.
But also among growth style, there were some interesting factors at play in 2017.
Outperformance of Mid-Cap Growth—Specifically Russell Midcap Growth
- Through September 29, 2017, the Russell Midcap Growth Index outperformed the S&P MidCap 400 Growth Index by 5.29%. Given that they are both U.S. mid-cap Indexes focused on the growth style, this is a large performance gap. To find another nine-month period where Russell outperformed to a similar or greater extent, we had to go back to the summer of 2003—about 14 years ago!
- Beyond that, we looked at rolling periods back to June 1995 to figure out how unusual outperformance of the Russell Midcap Growth Index over the S&P MidCap 400 Growth Index actually was. The Russell Index won only about 39% of the time in the analysis of rolling nine-month periods. As the rolling periods lengthened, it became less and less likely to see the Russell Index outperforming the S&P Index.
Russell Midcap Growth vs. S&P MidCap 400 Growth—Critical Differences
We dug further into the differences between these two Indexes. A theme that came up was that the S&P MidCap 400 Growth Index did bias a bit more toward higher quality and away from the more speculative firms that could qualify for the Russell Midcap Growth Index. That showed up in a few different ways:
- The average weight in the first nine months of 2017 to unprofitable companies was about 7.8% in the Russell Midcap Growth Index, but only about 3.6% in the S&P MidCap 400 Growth Index.1 This largely comes back to methodology, in that for initial inclusion, Standard & Poor’s does require proof that a firm has generated positive generally accepted accounting principles (GAAP) net income over the prior four quarters.2
- The sector picture was also quite different. For instance, in the Consumer Discretionary sector, the Russell Midcap Growth Index had more than four times the exposure to retailing (7.8% vs. 1.6%) than the S&P MidCap 400 Growth Index, and we know that the earnings environment has been very challenging for this sector. In Health Care, the Russell Index had more than twice the exposure to biotech as did the S&P Index.3
- Factor regression analysis going back to June 1995 also confirmed this result, as the Russell Midcap Growth Index had a -0.26 loading to operating profitability, whereas the S&P MidCap 400 Growth Index had a loading of 0.08.4
Unlocking the Key to the Difference between Growth Indexes
Differences like this can hold important keys to how the market—in this case, U.S. mid-caps—is behaving. If the Russell Index has opened up a cumulative performance gap over the S&P Index, the likes of which we haven’t seen for 14 years, that’s telling us that U.S. mid-caps are behaving in a much more speculative manner than usual.
Bottom line: What’s tended to work over the long term in U.S. mid-caps (quality and sensitivity to relative value, to name a couple) has not been working in 2017.
WisdomTree’s Mid-Cap Indexes Tilt Away from More Speculative Stocks
While the broader and more widely followed Russell Midcap and S&P MidCap 400 Indexes seek to include an array of both value and growth stocks—some of which may very well be more speculative in nature—WisdomTree’s mid-cap Indexes are attempting to deliver risk-adjusted outperformance over time. If the Russell Midcap Growth Index is outperforming the S&P MidCap 400 Growth Index (as we’ve seen this year), it signals that the market has become more speculative in nature, and we’d expect that WisdomTree’s approach might be at more of a disadvantage. Fortunately, these more speculative swings haven’t tended to characterize three-year, five-year or seven-year more strategically oriented periods—but they very well could have been great tactical trades.
Long-Term Performance Wasn’t Achieved during Speculative Upswings in U.S. Mid-Caps
Speculative Outperformance Is Nothing New, and It’s Not Supported by Longer-Term Studies
With everyone looking at factor research these days, it’s important to note that there is not yet any long-term data supporting the longer-term potential of more expensive or more speculative stocks. It’s important to understand that the first eight months of 2017 represent something we’ve seen before (and likely will again), but WisdomTree’s longer-term track record in U.S. mid-caps was still strong enough to deliver compelling performance over its full historical record.
1Sources: WisdomTree, Bloomberg, with period analyzed from 12/31/16 to 9/29/17.
2Sources: “S&P U.S. Indices Methodology,” S&P Dow Jones Indices, 8/17, and “S&P U.S. Style Indices Methodology,” S&P Dow Jones Indices, 7/17.
3Sources: WisdomTree, Bloomberg, with period analyzed from 12/31/16 to 9/29/17.
4Sources: WisdomTree, Bloomberg, Kenneth French Data Library, with regression analysis run on monthly data from 6/30/1995 to 6/30/2017.