Vanguard Mid Cap ETF: The Middle Risk/Reward Proposition (NYSEARCA:VO)

Graphs and charts

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As most of my followers know, I believe the best investment strategy for the average ordinary investor is to maintain a well-diversified portfolio built for the long term and to stay in the market through market cycles. But, of course, well-diversified can mean different things to different investors. Many Bogleheads feel that the best strategy is very simple: just hold a good low-cost S&P500 ETF. Indeed, research shows that the S&P500 outperforms the vast majority of ordinary investors and even a majority of professional money managers.

Over the years, I have come to adapt to that strategy. As you may have noticed from my popular Seeking Alpha article The 4-Fund Portfolio, I have been (slowly…) migrating my portfolio to fewer holdings (yet still a long way from 4!). Today, I will take a look at the Vanguard Mid Cap ETF (NYSEARCA:VO) to see if it deserves an allocation in a well-diversified portfolio built for the long term.

Investment Thesis

As mentioned in this article’s bullets, the mid-cap sector composes companies that generally have a much more established business plan as compared to small-cap companies. That being the case, the mid-cap sector can be viewed as kind of a middle-ground between the generally less-risky and less volatile large-cap companies that most all of you are familiar with and the relatively riskier and more volatile small-cap sector.

Mid-cap companies are also prime feeding ground for large-cap companies that, due to the law of large numbers, turn to mergers & acquisitions in order to maintain a strong growth trajectory. That being the case, mid-cap companies can often see their stock prices jump when they become the target of a much larger company’s M&A strategy.

The flip side of the coin is that the mid-cap sector can be infiltrated by companies that drop out of the large-cap sector and are moving down in the market food chain.

So let’s take a closer look at the Vanguard Mid Cap ETF and see how it is positioned to benefit investors going forward.

Top-10 Holdings

The top-10 holdings in the VO ETF are shown below and equate to what I consider to be a very well-diversified 6.5% of the entire portfolio of 380 companies.

VO ETF Top-10 Holdings

Vanguard

The first thing to notice is that there isn’t a significant difference between the allocation to the #1 holding and the #10 holding. That is why I consider this fund to be very well-diversified and not dependent on a handful of stocks to perform well.

The second thing I notice is that the #1 holding, Synopsys (SNPS), is a $45 billion company. So, those seasoned investors who have been around for a few decades likely need to re-calibrate their idea of what a “mid-cap” is today. Not too long ago, a mid-cap was generally defined as a company with a market cap of from $2-$10 billion. That definition is clearly out-of-date as a result of the mass capital appreciation of the broad market in general.

As for Synopsys itself, it provides electronic design automation software to help engineers more quickly design and simulate the integrated circuits (i.e., “chips”) that power the semiconductor sector. As design geometries continue to shrink, engineers have to consider more and more design rules and constraints and it would be impossible to design chips with billions of transistors without being heavily dependent on software automation tools like the ones Synopsys provides. For instance, consider the complexity of Apple’s (AAPL) M1 Ultra chip:

  • 114 billion transistors on an 840mm squared die.
  • 16 performance cores, 48MB L2 Cache.
  • 4 efficiency cores with 4MB L2 cache.
  • 64 GPU Cores.
  • Up to 128GB DDR5 memory at 800GB/s.

That is obviously a big, complex, and high-performance computer on a chip. No doubt Synopsys tools were used to see that design through to its fruition.

Note that Synopsys also has a thriving intellectual property “IP solutions” business selling prepackaged, verified, and commonly used chip-design modules like USB & PCI Bus interfaces, DDR controllers, Ethernet designs, HDMI & Bluetooth low energy interfaces along with including data converters and audio codecs. This is a very high-margin business for Synopsys and can be considered to be a SaaS-based model.

Cadence Design Systems (CDNS), the #5 holding, is in a very similar business and competitor of Synopsys.

With a market cap of $55 billion, Occidental Petroleum (OXY) is the #2 holding in the fund. When one considers OXY’s net debt ($25+ billion), one could argue that OXY’s enterprise value puts it into the large-cap sector. Regardless, OXY stock has been riding the current wave of high oil & gas prices, heavily influenced by Putin’s horrific war-of-choice in Ukraine, to great success – OXY is up 145% over the past year.

DexCom (DXCM) is a medical device manufacturer that focuses on the design, development, and commercialization of continuous glucose monitoring (“CGM”) solutions for the global market. Dexcom is up 24% over the past year and has a market cap of $48.3 billion.

The #4 holding is Centene (CNC), a multi-national healthcare company that provides solutions & services to the under-insured and uninsured in the United States. CNC’s Managed Care segment offers health plan coverage through government-subsidized programs like Medicare and Medicaid. CNC has outperformed the S&P500 by ~25% over the past year.

The #9 company is steelmaker Nucor (NUE) while the #10 holding is Microchip (MCHP), a semiconductor company (see my Seeking Alpha article Microchip’s SaaS-Based Model Yields Record Margins, Record Backlog, Strong Guidance, 5.8% Dividend Boost).

As you can see, the VO ETF offers a well-diversified list of companies that is quite differentiated from the IT-dominated large-cap funds (and the S&P500 itself).

Performance

The chart below compares the VO Mid-Cap ETF’s performance (middle column) with that of Vanguard’s corresponding sister funds, the Vanguard S&P 500 ETF (VOO) and the Vanguard Small Cap ETF (VB).

VO ETF Compared To VOO, VB

Vanguard

As can be seen from the graphic, Vanguard’s expense ratio gradually increases as the market-cap decreases, with the Mid-Cap ETF being in the middle with a still very reasonable 0.04% fee.

For those building a well-diversified portfolio built for the long-term, I direct you to the 10-year average annual performance numbers and note that the S&P500 wins by a considerable margin. Also, note that this is true no matter what time frame you choose to consider: YTD, 10-year, or any time frame in between. This certainly supports the Boglehead strategy mentioned earlier.

Risks

As for risks, I don’t necessarily consider the VO ETF to be much riskier than the plain-old S&P 500. That is because it is well-diversified across companies and sectors, is generally global in its reach, and – as noted before – these market caps are much larger than the Mid-Cap sector definition of your father’s generation. That said, I do generally believe that the Mid-Cap sector is somewhat less volatile and less risky as compared to the Small-Cap ETF (while delivering better total returns).

Summary & Conclusion

As part of my personal allocation of capital – and I practice what I preach when it comes to building and maintaining a well-diversified portfolio for the long term – I have held some VO & VB to balance out my VOO holdings. However, my allocation to Mid-caps and Small-Caps via VO & VB is only ~10% of what I have allocated to the S&P500 (i.e., VOO).

That said, as you can see by the performance stats above, and now that I have lived through both the pandemic market upside and the recent inflation & rising interest rate downside, I’m not sure what I am getting for my increased level of diversification into the mid-cap and small-cap funds. Getting back to my 4-Fund Portfolio and portfolio simplification theme, writing this article has opened my eyes and I may well rotate out of my allocation in VO and VB and consolidate those funds into my existing VOO position. The Bogleheads have a new fan.

That said, investors could certainly do worse than the VO ETF. It’s a high-quality, low-cost ETF that has delivered excellent total returns averaging 12.94% annually over the past 10-years. That being the case, I rate it a HOLD.

I’ll end with a 10-year price chart of the VO ETF as compared to the VOO S&P 500.

Vo price % change
Data by YCharts

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