The Middle Child

The Middle Child

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uch has been written about the supposed plight of the "middle child". Middle children, according to theory, are more likely to feel neglected, insecure, and unnoticed. Ok, whatever. How does this relate to investments? It turns out that neglecting the "middle equity index" is a bad idea. The middle equity index, in this study, is defined as the middle-of-the-road performer which doesn't garner the praise showered upon the top performing index nor the shame heaped on each year's underachieving index.

Six Wilshire U.S. equity indexes were examined over a 25 year period from 1979 to 2003. The indexes were large cap growth, mid cap growth, small cap growth, large cap value, mid cap value, and small cap value. Performance data were obtained from Morningstar's Principia.

As shown in Figure 1 performance data for the respective indexes (for both growth and value) are color coded. The blue shaded boxes represent the index which had the highest return in the prior year. The pink boxes identify the index (growth and value) with the lowest return in the prior year, and the yellow boxes highlight the index with the middle return in the prior year.

For example, among the three growth indexes, large cap growth had the lowest return in 1978 among the three growth indexes, hence the 23.84% return of large cap growth is highlighted in pink in 1979. Conversely, small cap growth is highlighted in blue in 1979 due to its return of 27.33% in 1978 (the highest among the three growth indexes). The 1979 return of the Wilshire midcap growth index is highlighted in yellow because it had the middle return of the three indexes in 1978.

This color coding scheme represents a portfolio management paradigm which either seeks to follow a momentum strategy (by choosing last year's best index - the blue colored cells); a bottom-fishing strategy (picking last year's loser - the pink colored cells); or a "middle-child" strategy (picking last year's middle performing index - the yellow colored cells). The results of these three strategies are compared against a buy-and-hold approach and an annual equal rebalance strategy.

Growth Indexes

Among the three Wilshire growth indexes the momentum strategy (shifting all assets into last year's best growth index at the start of each new year) generated an average annual return of 14.9% over the 25 year period. The standard deviation of annual returns was 20.9%. This type of momentum strategy generated a return superior to a buy-and-hold strategy using any of the three individual growth indexes.

A buy-and-hold in the large growth index had a 25 year return of 12.7% with a standard deviation of return of 20.7%. Buying and holding using midcap growth had a 14.1% annualized return with slightly higher volatility (21.9%). Finally, a buy-and-hold using only small cap growth had the lowest 25 year annualized return (11.8%) and the highest standard deviation of return of 23.9%

Equal annual rebalancing at the start of each year (achieved by shifting assets among the three indexes such that each index represents 33.33% of the total portfolio) among the three growth indexes generated a 13.0% return and a 21.3% standard deviation of return.

A bottom-fishing strategy among the three Wilshire growth indexes generated a 10.9% annualized return, the lowest among the four portfolio management strategies shown in Figure 1. Adding to the pain, bottom-fishing generated the highest standard deviation of return (22.9%).

The fourth portfolio management protocol is the "middle-child" option, namely reallocating all assets into the index which was the middle index in the prior year (i.e. neither the best performing index or the worst performing index). Interestingly, among the Wilshire growth indexes, this approach utilized the midcap index 16 times during the 25 year period. The "middle-child" approach generated a 25 year annualized return of 12.7% and a standard deviation of return of 22.8%. Among growth indexes the middle-child approach generated middle-of-the-road performance and volatility.

Value Indexes

The results using the three Wilshire value indexes tell a different story. Reallocating all assets into last year's middle index (yellow boxes) generated the highest return (17.4%) at a risk level (16.2%) comparable to the other portfolio management options.

The next best portfolio management option was an equal annual rebalance among the three value indexes. Following this strategy generated an annualized return of 15.4% and a standard deviation of return of 15.6%, which was the lowest level of volatility among the four active management options. (Buy-and-hold is considered a passive management option).

Next was the momentum strategy of reallocating all assets into last year's best performing index (blue boxes). This approach also had a return of 15.4% but at a slightly higher level of volatility of return (16.2%). A bottom-fishing approach (pink boxes) generated the lowest return (13.0%) and the highest volatility among the four approaches (16.9%).

Interestingly, a buy-and-hold approach using only the Wilshire small cap value index generated a return of 16.3%, second only to the "middle-child" (i.e. middle index) approach. However, the standard deviation of return was somewhat larger (18.4%). A buy-and-hold position in the Wilshire midcap value index had a 25 year annualized return of 15.8% and volatility of return of 16.1% which was comparable to the four portfolio management options. Finally, a buy-and-hold in the large cap value index had a return of 13.8%, superior only to the bottom-fishing management approach. However, a buy-and-hold in the large value index had the lowest standard deviation of return among the three indexes and the four portfolio management options.

The differential in annualized return among the different portfolio management options (either active or passive) may not seem substantial. However, when measured in dollar terms (Figure 2) the differences are staggering. For instance, among the three growth indexes, there is a differential of over $1,000,000 (assuming a $100,000 initial investment at the start of the 25 year period) between a strategy that shifts assets in the prior year's best index (blue boxes) and an annual rebalancing strategy. Among value indexes, the differential between the middle-index strategy and a buy-and-hold approach is nearly $2,000,000.

These results suggest that growth indexes (i.e. growth stocks) manifest tendencies which respond well to momentum portfolio management strategies. Alternatively, if populating a portfolio with value indexes (i.e. value stocks) performance might be maximized by focusing on last year's middle-child index. Additionally, a buy-and-hold hold approach is shown to be a strategy that produces reasonable, though sub-optimal, returns. Finally, a bottom-fishing approach is shown to be inferior among both growth and value indexes.

Bottom line: it pays to notice the middle child.

Figure 1. Growth & Value Indexes (1979-2003)

Blue = Highest Return in Prior Year,  Pink = Lowest Return in Prior Year, Yellow = Middle Return in Prior Year

Figure 2. Account Values after 25 Years

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Craig L. Israelsen, Ph.D. is an associate professor at Brigham Young University. He teaches family finance in the Department of Home and Family Living. His research interests include mutual fund analysis. He writes monthly for Financial Planning magazine.