A Mid-Cap Fund With a Purpose

As mid-cap funds go,

During the 10-year period ended Sept. 30, 2016, VXF returned 8.27% per year, outstripping the U.S. mid-blend Morningstar Category average by 1.48 percentage points per year. Much of this relative outperformance can be attributed to the fund's sizable fee advantage. At 0.09%, VXF's annual levy is a tiny fraction of the 0.97% median fee charged by its category peers.

This is not a typical mid-blend fund. Its larger exposure to micro-cap stocks brings the average market cap of the fund down to near small-cap territory. Smaller-cap stocks tend to be more volatile than large caps because they generally are less profitable and are less likely to enjoy competitive advantages. Their greater sensitivity to macroeconomic risks means that small caps are likely to underperform during market downturns. Both of these factors drive volatility higher than the typical mid-blend fund. The volatility of return on the S&P Completion Index as measured by standard deviation was nearly 4 percentage points higher than that of the S&P 500 during the past decade. Despite these risks, the fund still has an above-average level of return per unit of risk versus its peers over the long haul.

Fundamental View Each index provider defines mid-cap stocks slightly differently, but they generally account for around 7% to 20% of the total market capitalization of the U.S. market after the largest stocks, which make up 70% to 80% of the market in aggregate. Morningstar defines mid-caps as the 20% of the market after the largest 70%, which roughly corresponds to the next-largest 600 or so stocks after the largest 300. Given this fund's unique benchmark, it has a materially lower average market cap relative to its peers and plots at the low end of the mid-blend section of the Morningstar Style Box.

Mid-cap stocks have been in the sweet spot of risk-adjusted performance since 1926. Although they have historically had a higher return than large caps, they have also had a higher volatility and a higher beta, or more-procyclical movement with the market. But the higher return has compensated investors for the increased risk. While small caps had even higher returns, mid-caps have had a slightly better ratio of return to risk. For this reason, many investors chose to give an overweighting to mid-cap stocks. Yet there is no guarantee their past outperformance will persist.

Small-cap stocks, which make up more than a third of VXF's portfolio, have earned a return premium of about 2% over large-cap stocks since 1926. However, this premium can vary drastically over time and has become smaller in recent decades. From 1979 through October 2016, the large-cap Russell 1000 Index outpaced the small-cap Russell 2000 Index. During the entire decade of the 1990s, small-cap stocks underperformed large caps by 3% per year. While the small-cap premium may be unreliable, it has been positive during the past 15-plus years, as small-cap stocks have been on a tear since the tech bubble burst. This stretch of outperformance has caused small caps to look expensive relative to large caps.

In the late 1990s, large caps traded at a premium relative to mid- and small caps. But this situation has reversed, and mid- and small-cap stocks now command premium valuations. As of October 2016, the stocks in this fund's portfolio were trading at a price/prospective earnings ratio of 20.4, while the less-volatile large caps in the S&P 500 were trading at a more reasonable 19.0. The dividend yield on stocks in VXF's portfolio was about 1.7% versus about 2.3% for the S&P 500.

Mid- and small-cap stocks often lack economic moats, or sustainable competitive advantages. Consequently, they tend to be less profitable and less resilient in the face of economic turbulence. Morningstar equity analysts rate fewer mid- and small-cap stocks, but of those they do rate that are included in VXF’s portfolio, just 10.6% of the assets have wide Morningstar Economic Moat Ratings, compared with 49.2% for rated large-cap stocks in the S&P 500. Furthermore, stocks in the S&P 500 generated an average return on invested capital of 12% during the past year; the corresponding figure for those in VXF's portfolio was 0.9%.

Portfolio Construction This fund tracks the S&P Completion Index, which includes nearly all U.S. equities traded on a major exchange except for those in the S&P 500. While that means that the fund is mostly a mid- and small-cap portfolio, it includes a handful of large-cap stocks that do not qualify for inclusion in the S&P 500, such as recent IPOs or companies that do not meet the domicile, minimum float, or initial financial viability requirements of the S&P 500. This index effectively diversifies risk, promotes low turnover, and accurately represents its target market segment, supporting a Positive Process rating. The fund replicates the largest 80% of the index by market cap and then conducts portfolio optimization to gain exposure to small- and micro-cap names. This results in about 3,253 holdings from approximately 3,337 in the index. S&P uses some screening criteria to eliminate certain securities such as ADRs, limited partnerships, business-development companies, and illiquid securities from its universe. The fund's average market cap of $3.3 billion is much smaller than the $6.6 billion average market cap for the mid-blend category and closer to the $2.7 billion average market cap for the small-blend category. Exposure to real estate and consumer cyclical stocks is higher than the S&P 500, while exposure to consumer defensive, energy, and technology stocks is lower. The fund has historically used securities lending to generate additional income in an effort to improve tracking performance.

Fees This fund levies a low fee of 0.09%. The fund's expense ratio is a fraction of the 0.97% median levy taken by its category peers, meriting a Positive Price Pillar rating. During the five-year period ended Sept. 30, 2016, the fund outperformed its benchmark by 9 basis points per year. This implies the fund has been able to more than offset some of the drag created by its fee through a combination of savvy portfolio management techniques and securities lending.

Alternatives

Investors have a variety of choices to obtain exposure to mid- and small-cap stocks. Within the Vanguard family there is

Those looking for exposure to the total stock market might consider

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.