An Active Approach to US Mid-Cap Equities for DC Plans

Gauri Goyal: Hello, I'm Gauri Goyal, Director of Content Solutions at Pensions & Investments. I'm pleased to welcome our speakers from Invesco: Greg Jenkins, Managing Director and Head of institutional Defined Contribution, and Justin Livengood, Senior Portfolio Manager and Senior Research Analyst. Thank you both for joining us and for sharing your insights on Invesco's active approach to U.S. mid-cap equities for DC plans.

So, Justin, to start with you, what are the underlying fundamentals that make U.S. mid-cap growth a compelling opportunity today? And could you share how you define the mid-cap growth space?

Justin Livengood: We define mid-cap growth as companies with market capitalizations between $5 billion and $40 billion, which is how our benchmark also describes the universe. And what we really find interesting about the mid-cap space is that it's in this range of market capitalization that you find companies that have reached the inflection in their corporate lifecycle. So small-cap companies are still figuring out their business models and their management teams are still coming together. Large-cap companies, by contrast, are much more mature and at a slower point in their corporate growth. Mid-cap companies, though, have reached that sweet spot, that perfect point where the business model has been vetted, the management team has been optimized, market share gains are really starting to kick in and you get some of the best value creation in any part of the style box. We're especially interested on the growth side of mid cap, because it's there that you find a lot of the strong, disruptive, innovative companies that are reshaping the world today. We at Invesco in this strategy focus on secular growth, premier companies, many of which are in the technology and healthcare sectors that are the dominant sectors in that mid-cap growth style box. We’re attracted to owning those innovative, new, up-and-coming companies that have reached that inflection point that often happens for companies of this market-cap size and that are, we think, addressing great opportunities over the next three to five years across a variety of sectors. Again, that is particularly in information technology and in healthcare.

Goyal: That gives us a really good picture of the opportunity set for investors. Moving to you, Greg, what can mid-cap growth exposure deliver for DC plan participants? Where on the glide path is it optimal to have this exposure?

Greg Jenkins: So, there's no question that participants need growth along their retirement savings journey, and they'll depend on equities for much of this growth. Given that, it's important that participants equity exposure is diversified. Participants of nearly all ages can benefit from mid-cap exposure. And as Justin talked about, this is where some of the most exciting growth in our economy is taking place and there's evidence of strong risk-adjusted returns over the long run. Younger participants, in particular, have a primary objective of growth and mid-caps can serve an important role here. So, when reviewing target-date funds, plan sponsors should not only look at the asset allocation overall, but also the diversification in the underlying equities and make sure that participants are getting the diversification that they need.

Goyal: Absolutely, it seems that the exposure to this sector can be beneficial, as you said, across the lifecycle. Justin, could you share Invesco's active management approach to identifying premier growth companies and what that brings to the mid-cap strategy. And perhaps share some examples of mid-cap sectors where you see opportunity today?

Livengood: Our investment process focuses on really well-managed companies with the ability to grow at above average rates in their respective sectors. And that typically leads us towards more secular growth companies that aren't as exposed to what's going on in the economy. We feel that's a particularly attractive profile, given what's going on currently in the world where we are of the belief that the global and U.S. economies will be going through a tougher phase over the next year in light of inflation, hawkish monetary policy, geopolitical issues, etc. So, we think that companies that are able to grow in spite of those macro challenges are going to stand out. That's informed some of our recent investments and tilts in the portfolio. Here are a few examples. One area that we're particularly interested in is healthcare, which is doing quite well. It's mostly domestic industry, it's not typically very cyclical [and] there are a lot of parts of health care, like managed care and pharmaceutical distribution, that actually are able to benefit from inflation and pass through higher prices to their customers. So, we're very attracted to parts of the healthcare industry. A second area that we find really interesting are service companies, business service companies, companies that do things like waste management services. [These are] very resilient business models that aren't going to be affected by GDP or corporate earnings broadly. [Also,] information technology service companies that are typically on subscription business models; again, very high-recurring, high-visibility type profiles. A third and final area that we're interested in is real estate REITs: commercial real estate companies that benefit in two ways from higher inflation, both the underlying value of their properties are, at the moment, seeing a lift in value, but also, they're able to raise rents or leases to reflect the higher inflation environment that we're in. So, we see real estate, we see service companies, particularly business service companies, and health care as three areas at the moment that really fit our investment process well in this challenged macro environment.

Goyal: Thank you. So clearly a compelling opportunity overall and some attractive sectors you're looking at. Given that Greg, why is the segment been overlooked by plan sponsors and participants in the DC core menu? That's something that's been referred to as the 'mid- cap gap' in DC plans.

Jenkins: So, data shows that in aggregate, DC plans tend to be overexposed to large-cap equities. When you look at the Callan DC index data, for instance, about 28% was allocated to U.S. large-cap by the end of 2021, compared to only 9% in small- and mid-cap. The imbalances increased actually over the last 10 years. When you look back at data, for instance from 2013, you can see that participant assets were about 12% in small- and mid-cap equity. The effect is even more prevalent in public DC plans. Data released last year by the Public Retirement Research Lab shows that 32% of assets in these plans were invested in large-cap domestic equities. So why this gap exists is not an easy question to answer. Many plans simply have more large-cap options. Some don't have a mid-cap option at all. Additionally, you could argue that just a handful of large U.S. companies like Apple and Google have garnered so much of the attention from investors in recent years. So, the statistics give us some clues. But what really matters, of course, is in your DC plan and your clients' DC plans. And I encourage [plan sponsors] to strongly take a look at your participant allocation data to see if there are any gaps or imbalances. Equities are important for participants as we talked about, of all ages and mid-cap growth is a category that you may want to consider.

Goyal: Thank you both for sharing your perspective on both the opportunity and the benefit of mid-cap growth exposure for DC plan participants.