A reader writes in, asking:
“I notice that in your ‘8 lazy ETF portfolios‘ article, there are exactly zero funds focused on mid caps, but several ETFs focusing on small caps are included in the various portfolios. I guess my question is… why is this? I’m seeking to weight my Vanguard Roth more heavily toward smaller domestic stocks, and I don’t quite understand the lack of interest in mid cap.”
When it comes to diversification within the stock portion of one’s portfolio, there are two schools of thought within the broader “passive investing” group of investors.
Diversification via Number of Stocks
One line of thinking is that, once you have an allocation to as many stocks as possible, you cannot get any more diversified. In other words, with regard to US stocks, a “total market” fund is as diversified as you can be, because it already includes the entire US stock market (or as close to it as possible). And ditto with a “total international” fund.
This is the line of thinking that Allan Roth, for example, is using with his “Second Grader Portfolio.” It’s also the line of thinking that Vanguard uses with their Target Retirement funds (which hold three underlying funds: Vanguard Total Stock Market, Vanguard Total International Stock, and Vanguard Total Bond).
Diversification via Risk Factors
Twenty years ago, researchers Eugene Fama and Kenneth French found that certain types of stocks (specifically, small-cap stocks and value stocks) perform noticeably differently than other stocks (specifically, they have higher returns, presumably due to higher risk).
The second school of thought within the broader “passive investing” school argues that additional diversification can be achieved by exposing one’s portfolio to a significant amount of small-cap risk and value risk in addition to normal stock market risk. And, naturally, the easiest way to do this is to add a fund all the way at the small-cap/value end of the spectrum rather than going only half-way down the spectrum with mid-cap funds.
Where Do Mid-Cap Funds Fit?
In other words, there’s nothing at all wrong with mid-cap funds (or, more broadly, with mid-cap stocks). They just don’t fit very neatly into either of the two major schools of thought. One school of thought thinks a total market fund is all you need. And the other school of thought, seeking to achieve small-cap exposure in the easiest way possible, goes directly to small-cap funds as a way to supplement a “total market” holding.