Best Midcap ETF? Small Fry Crushes The Big Boys

Midcap stocks have delivered better performance than large caps of late. That’s attracted plenty of money into exchanged traded funds that specialize in midcaps. The iShares Core S&P Midcap ETF (IJH) has more than $16 billion in assets, and the SPDR S&P Midcap 400 (MDY) is now at $12 billion.

Both those ETFs are catnip for money managers whose performance (and ultimately compensation) is based on how they stack up relative to a given benchmark. Given that the S&P Midcap 400 index is the standard-bearer of midcap indexes, investing in funds that hug that index assures you won’t have tracking error come evaluation time. For investors freed from such constraints, the $214 million Wisdom Tree Midcap Earnings ETF (EZM) is an intriguing alternative.

EZM Chart

EZM data by YCharts

The small fry WisdomTree ETF’s 24% gain over the past year also beats the big boys by more than two percentage points. What’s interesting is that the outperformance isn’t fueled by an overweight in pricey segments of the market. According to Morningstar, WisdomTree Midcap Earnings has a forward price/earnings ratio of 14.7, a steep discount to the 18x for the S&P Midcap 400 index.

WisdomTree’s proprietary indexes are known for eschewing the mainstream trend of weighting holdings based on market cap. For this midcap ETF the portfolio is based on the dollar value of earnings churned out by a company; the more earnings you produce, the bigger the weight. That can be an especially smart approach to midcaps where you’ve got faster-growing companies than in the S&P 500. Drilling down to the earnings machines within the midcaps tilts you toward the companies that are delivering the most growth. That isn’t necessarily the case with the S&P 500, where even a slow grower (Exxon-Mobil (XOM), for example) can still have the highest aggregate earnings in dollar terms. WisdomTree’s Earnings 500 ETF (EPS) has barely edged out the S&P 500 index over the past five years. Decent, but not stand-out.

The Midcap Earnings ETF is constructed by starting with WisdomTree’s comprehensive Earnings Index, that includes caps large and small that are spitting out earnings. The 500 largest companies in terms of market cap are lopped off to get rid of most of the large-cap presence. The index then drills down another layer by focusing on the remaining companies in the top 75% based on market cap. (So another 25% is lopped off based on market cap.) The survivors are then weighted by the dollar value of their core earnings. The upshot of all that jujitsu is a portfolio with about 85% of its assets invested in companies with market caps between $2 billion and $10 billion. (The other 15% is small caps.)

The core bit is important; WisdomTree’s methodology focuses solely on earnings from continuing operations. You won’t see any one-quarter or one-year wonders that got an earnings pop from a sale, or some accounting one-off.

There are more than 600 stocks in the portfolio. After exporting the top 100 holdings into a YCharts watchlist you can slice and dice away. Ranking on Operating Earnings Yield turns up one of the few midcaps with name recognition, AOL (AOL), with an operating earnings yield of 32.8%. Yep, this is a fallen large-cap….that was spun off in late 2009 after the epic fail merger with Time Warner. But if you let go of that historical baggage there’s a pretty interesting earnings story here.

AOL Chart

AOL data by YCharts

Among the top 10 in the watchlist ranked by operating earnings yield, Apollo Group (APOL), US Airways (LCC), Cooper Tire & Rubber (CTB), Exelis (XLS), Reinsurance Group of America (RGA) and Delek US (DK) all have forward PE ratios below 10.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.

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