S&P Issues Report on Mid-Cap Funds in DC Plans

In its report, “Mid-Caps in DC Lineups: Considerations for Plan Sponsors,” S&P looks at why the vast majority of defined contribution (DC) plans offer at least one index fund, which are mostly concentrated in the large-cap segment of the U.S. stock market.  Passive funds representing other asset classes are offered in far fewer plans, which may be due to popular misconceptions about the efficacy of indexing in markets that are perceived to be less efficient than large-cap equities.  S&P considers the basis for this perception, and explains why it believes the notion is unfounded for mid-cap equities.   

While companies in the mid-cap segment of the stock market are more mature than small-caps, many may have strong growth potential relative to large-caps. Their unique fundamentals produce a distinct performance profile, says S&P. Over the past decade, many investors – and the fund industry – seem to have embraced the notion of including a dedicated allocation to mid-cap equities in their portfolios. The number of actively managed mid-cap mutual fund products increased from 216 at the beginning of 2000 to 461 at the beginning of 2010. 

The report also asks if DC plan participants are well served by actively managed mid-cap choices, or is this a relatively efficient asset class where indexing works? Analysis shows that more than three quarters of the most widely used mid-cap funds in DC line-ups have underperformed the S&P MidCap 400 over the three years ending March 31, 2011.  

Picking active mid-cap managers is risky for plan sponsors, the report said. Over three-, five- and ten-year periods, active funds that failed to beat the benchmark did so by a significantly larger margin than the amount by which outperformers beat the benchmark.  

Despite this evidence suggesting indexing mid-cap exposure is highly effective, less than 20% of DC line-ups in the survey have a passive mid-cap option available for participants.  Contrary to conventional wisdom, indexing is a highly effective means of gaining exposure to market segments beyond large-caps, S&P notes. Mid-caps are not immune to the “arithmetic of active management.”