Mighty mid-caps
So, why have mid-caps beaten large-caps so resoundingly? One explanation is that medium-sized companies are nimbler and have better growth prospects. Of course, financial theory says that higher returns can only come at a cost of greater risk. For example, FTSE 250 shares are less liquid than FTSE 100, which is one source of risk. However, is it really the case that the mid-cap index is a much riskier overall?
Much depends on how we define risk. For me, performance at times of extreme financial stress is a particularly relevant measurement. In three of the four really big market crashes since 1986, the FTSE 250 did indeed do worse than the FTSE 100, as theory would predict. However, the difference wasn’t all that much. In the stock-market slump resulting from the credit crunch, the FTSE 250 shed 53 per cent, compared to 48 per cent for the FTSE 100.
Ideally, what we would attempt time our investments in the FTSE 250 in order to minimise our exposure when its prospects are least promising. Of course, this is more easily said than done. However, I have lately tested an approach to timing the FTSE 250 index based on the ShareMaestro investment software, of which I am the creator.
ShareMaestro has a solid track record of highlighting the best times to be in and out of the FTSE 100 index. In my book How to Value Shares and Outperform the Market, I discuss how the FTSE has produced annualised capital gains of 15.9 per cent during periods when the ShareMaestro model said the index was undervalued, and 0.7 per cent annualised gains during periods of overvaluation according to the model.
Since the FTSE 250's major turning-points have been very similar to those of the FTSE 100, I decided to investigate whether ShareMaestro's signals for that index were also useful for calling the FTSE 250. The answer is a resounding 'yes'. Since 1986, the average capital gain in the FTSE 250 for periods when the model rated its sibling as undervalued was an annualised 18.7 per cent, compared to minus 0.7 per cent for periods when the FTSE 100 was overvalued.
What strategies might we use in order to profit from the FTSE 250 using ShareMaestro signals for the FTSE 100? The simplest approach is surely just to buy and hold a FTSE 250 index. The long-term total return on the mid-cap index - i.e. with reinvested dividends - has been 11.6 per cent. That’s much better than the average long-run performance of UK equities as a whole.
If you aspire to boosting your performance via market-timing, however, you could buy a FTSE 250 index ETF whenever ShareMaestro says the FTSE 100's instrinsic value is at least 105 per cent of its current price, and then selling the FTSE 250 index and holding cash instead whenever the FTSE 100's intrinsic valuation goes below 95 per cent of the current price.
The most aggressive approach would be to trade the FTSE 250 index via spread bets based on ShareMaestro's buy and sell signals for the FTSE 100, an approach I considered for the large-cap index in this piece http://bit.ly/VYxRKz. If the future resembles the past, such a strategy would produce excellent returns, although strict risk management would be needed.
