More investors picking midcap

Institutional investors are gradually turning to midcap strategies as a source of alpha, now that more small-cap offerings have been shuttered because of capacity constraints.

About 15% of U.S. active equity placements by defined benefit plans, foundations and endowments have been tied to midcap core, growth and value mandates so far this year, up from 7% in all of 2004, according to Holmes Research LLC, Louisville, Ky. The demand is less robust than in other asset classes such as U.S. active large-cap equity — with 43% of placements, by Holmes' count — but consultants said the recent midcap pickup will likely continue.

"We see steady demand … in terms of replacement search activity for existing midcap managers, as well as a gradual increase in the number of investors using midcap," said Rich Nuzum, national business leader for Mercer Investment Consulting, New York. He estimated that midcap allocations among Mercer's institutional clients jumped 10% year over year as of mid-August.

Plan sponsors are reaching for midcap because more small-cap strategies have hit peak capacity following strong performance in recent years, said Roz Hewsenian, managing director at Wilshire Associates Inc., Santa Monica, Calif.

"We're seeing more interest in midcap than we have previously because a lot of small products are closed," she said.

Managers with dedicated midcap offerings, as well as small-cap to midcap strategies, are more than happy to serve the overflow. Ariel Capital Management LLC, Chicago, has won three accounts for the midcap Ariel Appreciation Fund and one account in its midcap value tax-exempt strategy since the beginning of the year, said Roopa Patel, vice president.

"There are still (investors) who don't have a dedicated manager," said Mellody Hobson, president of Ariel Capital, noting that her firm sees midcap holes to fill, especially on the 401(k) side.

EARNEST Partners, Atlanta, has 10 new midcap equity accounts this year, according to institutional research firm eVestment Alliance, Atlanta. That compares with seven in all of 2004. Trey Greer, partner at EARNEST, declined to comment.

Chicago Equity Partners LLC, Chicago, has won nine midcap core equity accounts since early January, eVestment Alliance found. So far, that is consistent with the nine accounts brought on in all of 2004.

"The (midcap) space has done well," said Patrick Lynch, president at Chicago Equity Partners. "(It is) is a pure play on the U.S. economy. Smaller companies are targets for M&A activity by bigger companies, and plan sponsors want to make sure they have exposure there."

The $13 billion Kentucky Teachers' Retirement System, Frankfort, is among institutional investors looking to fill a new midcap allocation. On the advice of its consultant, Chicago-based Becker, Burke Associates Inc., the system decided putting $300 million into active midcap growth would be a "sound investment to diversify our portfolio," said Gary Harbin, executive secretary.

"We would not have to depend so much on large-cap stocks to do it all," Mr. Harbin said, noting that the board will likely announce a hiring decision at its Sept. 2 meeting. He declined to offer more details.

Chicago Equity's Mr. Lynch said many of his clients don't want to miss out on midcap exposure. "Historically, plan sponsors (used) large-cap managers that perhaps cheated down a bit and small-cap managers that cheated up a bit, and midcap was taken care of, vs. having a dedicated commitment to the space," he said.

Firms such as Denver Investment Advisors LLC, Denver, and Roxbury Capital Management LLC, Santa Monica, Calif., have created presentations to communicate the merits of midcap, highlighting aspects such as better returns and lower risk. DIA, which ran $2.1 billion in midcap value and growth strategies as of June 30, emphasizes that midcap stocks have consistently outperformed small- and large-cap stocks during the past 20 years.

For example, the Russell Midcap index has generated three-year annualized returns of 15.9%, compared with 12.8% for the Russell 2000 and 9.2% for the Russell 1000. Over 20 years, the Russell Midcap has returned an annualized 13.7%, vs. 10.6% for the Russell 2000 and 12.2% for the Russell 1000, according to the DIA presentation.

Terri Baldwin, director of institutional marketing at DIA, said the firm is participating in several midcap searches now. She declined to offer specifics but noted that the firm's year-old SMID strategy allows it to further capitalize on the market opportunity at hand.

Roxbury is a finalist in two midcap searches, a $40 million midcap value mandate and a $40 million to $45 million "non-large-cap strategy" mandate in which the firm is presenting its midcap growth strategy, said Jon Foust, director of marketing and client service.

Investors might become more creative with their midcap exposure, said Monica Butler, managing director, U.S. consulting, Russell Investment Group, Tacoma, Wash. She said some clients are thinking about using midcap strategies in a portable alpha context, porting alpha from the midcap sector to a large-cap portfolio, for example. Overall, interest by Russell clients in midcap strategies is increasing at a "marginal rate."