Talk Your Book: Elevator Growth in Mid Caps

0:00Today's Animal Spirits Talk Your Book is brought to you by State Street Global Advisors. Go to SSGA.com to learn more about the SPDR S &P MidCap 400 ETF, ticker MDY. That's SSGA.com to learn more.

0:16Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions. Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46Welcome to Animal Spirits with Michael and Ben. On today's show, we are joined by a recurring guest, Matt Bartolini. Matt is a managing director at State Street Global Advisors and head of Spider America's research team. He knows all the ins and outs of the ETF industry. On today's show, we spoke about primarily mid-caps. I feel like they're an overlooked area of the market, especially amongst advisors. You talk about either allocating to large versus mid, or do we do cap weight versus equal weight? And the mid-cap 400 is a forgotten index. So I spoke about this in the show a little bit. My boss thought he had the markets figured out by investing in mid-caps because he thought no one else did.

1:22And in the 2000s and the 2010s, its strategy really paid off because mid-caps did really well in the last decade. And then they kept up reasonably well in the 2010s when the S &P kind of took off too. You know what we didn't ask, Matt? The migration in size as the market has drifted higher. Mid-caps are now large companies. I think on the high end, he said it was like 18 billion, right? It's way bigger than it used to be. It used to be 10 billion was the cap or something. That's inflation. So we covered a lot of ground in mid-caps. And then we also spent the last part of the conversation talking about ETF world.

1:54Matt is head of ETF research at State Street. So he has his finger on the pulse of active ETFs and duration where people were supposed to go for fixed income and gold and all that good stuff. So here's our conversation with Matt Bartolone from State Street.

2:09Matt, welcome to the show. Yeah, thanks for having me, guys. So my first real job in this industry, I worked for doing asset allocation work for pensions and endowments and foundations. and my boss back then had a real big affinity for mid-caps. And his whole thesis was, it's the biggest overlooked area of the stock market because typically this is how it was done is you had your large cap manager or position and then if you wanted to take a little more risk or have some diversification, you also had a small cap manager. And his contention was that middle ground kind of was an afterthought to most people and not enough people allocated there.

2:51And he liked the diversification benefits. And it was like the companies were a little more mature, but not quite there yet and had some runway. Does that make sense of the thesis to you? Like, what is the selling point for investing in mid-caps? Yeah, I mean, I think it comes down to overlooked and under-researched, right? So they're overlooked by Wall Street analysts, folks that go on TV to talk about the latest stock. They usually anchor in on some glamour stocks, right? Analysts typically will focus on more large cap names because that's the ones that are going to get the investment banking revenue and be longer, bigger clients for the broader bank.

3:28So the analysts focus on the big market capitalization names. Meanwhile, academics, because of whether it's Fama French's paper in 1992 or then the legions after researching the small cap bias, where if you look even in the social science research network, There's far more papers written about the size premia than there is about mid caps. So you have an overlooked bias from Wall Street analysts, and then you're under researched from academics. And that leaves this pile of names right in the middle that have that operational dexterity of a large cap multinational firm with a going concern, diverse client base.

4:09But the sort of managerial entrepreneurship of a small cap stock that still has room to grow and become a bigger household name. Does the S &P 400 and State Street's ETF, ticker for that is MDY, does the S &P 400 work like the same way with the committee for the S &P 500, which is cap weighted? Because I'm looking at the holdings and it looks very different. The weightings. Yeah. So the 400 is going to be, obviously, once the companies in the 500 get selected, the next ones drop into the 400. Right? So there is that sort of committee approach that started with the 500. But also when we look at it, there's a profitability screen that goes into the mid-cap 400 as well as the 500 and the 600.

4:52But also, even though there's a band associated with it, like the mid-cap banding, I think, is between$7 to$18 billion. There are firms that are over$18 billion in it just because they were like the 502nd or 503rd firm. And they get grouped into the 400 just as a result of that. But I guess specifically the weight of the holdings, it doesn't look cap-weighted. You mean because there's not as many big holdings or what? No, MDY would be cap-weighted. Oh, it is? Well, because I'm looking at the top 10 holdings and RB Global is number one, Interactive Broker is number two, DocuSign's in there. But it looks like it's like 65 basis points, 65, 63, 62.

5:33It looks like much, much more, I don't know, equally weighted versus the S &P. So it's definitely not equally weighted. It's going to be less concentrated because you don't have the same concentration bias. You don't have the same concentration bias that you do have in those mega cap tech stocks. There's more. All right. I feel like an idiot. I guess just by definition, there is not going to be the mega outliers. Yeah, they're not going to. Because if that company becomes that mega outlier, they're going to graduate, right? They're going to go into the 500. So I guess it would look like that at the bottom of the S &P 500 too, right?

6:06Where the companies are all much in a tighter group. So that's interesting. So I guess in a way you'd think of a mid cap a little bit more like an equal weight, probably. And I think that the tendency is the equal weighted S &P probably has similar performance to the mid cap. Is that fair or not really? No, probably not. I mean, you're going to have sector differences like equal weight is, you know, is going to be just big into industrial firms because there's like 70 of them. Right. Mid caps are going to be based on, you know, who's in the underlying index, you know, what companies are more representative of a smaller type stock that has, you know, some ability to grow and have positive revenue.

6:47So I don't think it would be natural one to one. But I think this idea of how do I invest in the U.S. but do so in a less concentrated way than I get with the S &P 500 mid caps can offer you that they can help solve for this concentration bias. So we're recording this on March 31st, and there is a lot of news in the headlines. Tariffs, obviously. Growth is slowing. The Mag 7 are getting hit pretty hard. Every one of the constituents other than Apple is in a 20 % decline, some obviously much larger than others. If you look at the weightings of the mid-cap 400 sector on the sector level, it looks quite different.

7:29Let's see. What is tech in here? It is? It's about 10%. Okay. So is this another way to, I hate to use the phrase play, but whatever, to get exposure to corporate America without being all in on the tech giants, which at their peak were 35 % of the S &P 500? Yeah. So I think there's a couple of things to this is that tech had been around 16 % prior to, I'd say 2021. And then you had the significant drawdown of 2022 that wiped out a lot of tech stocks that have not the same multinational profile that the MAG-7 do. So this 10 % is quite near the nadir of where they've been historically. But it does allow you to own a broader representative slice of the U.S.

8:16equity market and diversify away from a very MAG-7 heavy S &P 500 exposure. And it allows you to be more domestic in nature, too. A significant amount of portion of the revenue from mid-caps comes from the US, which would be different than what is transpiring in the S &P 500, where it's like 40%. Why do you think – if some people have that mindset where they're like, listen, I want to be invested in larger stocks. I just don't want all of my eggs in – or a lot of my eggs in that tech basket. Why do you think the default is to maybe equal weight the S &P instead of looking towards mid-caps? I don't know.

8:54No, I've never found the S &P 500 equal weight to be that intelligent of a strategy. It literally is equal weight in the names and your sector concentration is only going to be a direct result of the number of stocks in that sector. So you're just trading your biases. You're trading concentration bias from market cap to then sector biases that will then ultimately drive returns. Oh, I never thought about it that way. Yeah. Yeah, I mean, if there's like 100 energy. So if there's more names, regardless of the weight of that group. So if energy, for example, was just 4 % of the market, but there happened to be 70 energy names, you would have a massive overweight energy.

9:30Yeah. You would have 7 % like that, quick math. So yeah, it doesn't make any sense. That's a lot of courage. Quick math on a podcast, credit to you. Yeah, I don't think it was right though, but it's not early. It's actually late here in Boston. But yeah, I never found it to be that compelling of a strategy. I think there's better ways to reduce your concentration without taking on sizable biases to sectors. And as we all know, sector returns are pretty significant in terms of the driving overall return profile of an exposure. And that's why mid-caps allow you to reduce your concentration risk, but still remain invested in U.S.

10:10equities while not sort of disrupting how those firms are generating cash flows, right? These mid-caps that generate a lot of cash flows, they're going to be at the higher end of the spectrum. I know we're still thinking through all this tariff stuff on the fly here, because I think the White House is doing the same. So we don't have any certainty yet. But a lot of the stuff I heard coming into the year and thinking about the policies was, well, you would think small and mid-cap stocks actually are better positioned than large-cap stocks, because the large-cap stocks are so much, those corporations are so much more global.

10:42And you mentioned a lot of the revenue for smaller and mid-cap stocks tends to come from within our borders, right? So does it make sense that these companies wouldn't be harmed as much? Or you cannot think of it like that because while they still have to import parts for a lot of their, whatever they're producing or what they're doing. And I know it's, there's a lot of different moving pieces here, but does that theory make sense in any way? Well, I think like if you look at small caps, small caps have not done well, right? So you say that they're far more domestic than anybody else, but they haven't done well because they're also probably not as profitable as everybody else.

11:15So I'd want to make sure you have a profitable base. But when I just compare large caps that are more multinational, what is transpiring is that the entire market was heading into the year was discounting the fact that the growth that we've seen from large caps will continue in the matter which it has had. So the last five years, they've been able to grow, grow, grow because of globalist policies that allow for expansion of business models. And now all of a sudden, that could be disrupted. So S &P 500 firms generate 40 % of their earnings from overseas. If all of a sudden you have sort of retaliatory measures take place in the countries in which they operate, and now they cannot generate that cash flow, that is what we're seeing now.

11:58And there's a re-rating in terms of the price to earnings multiples. So I think where you sit in terms of how you navigate these tariffs is that we're looking out at a new world where US asset exceptionalism is probably not going to continue in the manner in which it has because we're not going to have so many global growth opportunities that really supported the rally over the last 10 to 15 years. And if you make that case, then mid caps actually look quite attractive because on a valuation basis, they are far more attractive. Yeah, the valuations in small mid-caps never went crazy like the S &P, right?

12:35They're at or below long-term averages, I guess, depending on how you define that? Yeah, in and around there. I mean, on a relative basis to their own history, they're a little bit stretched. But I think that just also is a semblance of sort of the U.S. sizable performance advantage. Because if you look at it was heading into this year, in 13 of the last 15 years, mid-caps had outperformed non-U.S. equities. And that's just mid-caps because everyone sort of points to US large caps being this world beater, but actually extended beyond just large caps. It was mid-caps too. They were able to benefit from an expanding overall asset base.

13:12What do you make of the argument that goes like this? If you're investing in the mid-cap, you're not letting your winners run because the biggest stocks eventually graduate out of it. And so there's a natural cap on how this group can do. I think that's a fair assessment. However, you're able to capture that elevator level of growth, right? So they're going to go from small caps to mid caps to large caps. So you're going to capture them graduating on up and then replenishing back and forth and back and forth because there'll be new mid caps that come up and take their place and continue to grow and grow and grow.

13:49I mean, some of the historical names that have been mid caps, NVIDIA was a mid cap. If you were able to partake in that growth at some point. And I would not want people to try to think that they can time that growth, right? Timing that single stock growth is really hard. But if I know I have an exposure that's going to pick up these companies systematically throughout time and see them mature their business model to then become either a global behemoth or someone like JetBlue who flies everywhere. What do you make of the shrinking public equity market? Just the number of stocks peaked in the late 90s at 7 ,000.

14:27Now it's down to less than 5 ,000 or somewhere thereabouts. Does that make the mid-cap more of a stale index? Is it less dynamic than it used to be because fewer companies are coming to the market? No, because the profitability screen is really important within the mid-cap space for the S &P 400, where you have to have four consecutive quarters of positive earning per share. So if you have a lot of IPOs coming to the market, a lot of those other stocks that they probably weren't profitable. And the lack of public equities is just a byproduct of the rise of private equity. And maybe some of these companies that would have been in mid caps have probably been taken out.

15:06So to that extent, yes, there's probably some limitations to it, but still a representative basket of 400 stocks that have those mid to small size market capitalizations and some potential earnings growth. Yeah, it was mostly micro caps, right? That was a lot of those ones that were public. They're not getting it was micro cap. I'm sure some of those graduated, but most of them probably just would have went away anyway. Yeah, I mean, I still think there's a decent amount of mid cap stocks to include. I mean, just been looking at the, you know, some of the names that are at the top end, you know, they perhaps would have been large caps, there was not a hard cap at 500 stocks.

15:40And so you still have some diversity of names throughout. And I think just going back to the original question, or one of the original questions around the weightings, where they do sort of look a little equal weighted, is because there's a lot of diversification within those 400 names. Are you starting to hear from more advisors asking about the mid-cap space as the MAG7 hit the skids? So we're getting questions around how to reduce concentration risks within portfolios writ large, whether it's equities or just within the 60-40, where equities dominate so much of the risk profile in any event.

16:15I mean, I think it's like 91 % of the contribution or risk in a 60-40 portfolio comes from equities. And then if you're buying just large caps, you're now just doubling down on that same concentration risk because large caps are massively concentrated. So the question that comes up is how do I remain invested but reduce my concentration? And there's a handful of options that we have, mid caps being one of them. And I think it is somewhat telling. We are, it's March 31st, or I'd say effectively at the end of the month. $2 billion have come into mid-cap ETFs this month. Not saying that that is a telltale sign that our sort of insights have been taken, but I think it is just constructive because small caps have had outflows.

16:55And I think a lot of people are bearish on small caps just as a result of the sort of potential economic impacts of some of the political uncertainty we're having. I want to circle back to the profitability thing, because I've always heard that the difference between, say, the S &P 600 and the Russell 2000 on the small cap side is that profitability screen, right? And in the small cap space, the number is something like 40 % of those stocks are unprofitable. So you want to have a profitability or quality screen there just to wean off the really bad companies. Does it work like that in the mid cap space too?

17:27Or are there far fewer offenders that are unprofitable there to choose from? So it's kind of funny that there are going to be fewer offenders in that space, right? because you typically, if you're in the 600 and you graduate to the 400, you probably have had some positive earnings per share growth at that point. I think what it does do is, maybe, you know, maybe it shouldn't highlight this because it's somewhat of a negative, but Amazon, technically by market capitalization could have been a mid cap, but it wasn't, didn't have profitability for four consecutive quarters way back when. Then of course it did, and it was in the 500.

18:04So there could be some downside to it, but ultimately it has been a positive because I think on balance, it's always better to have a profitable company than an unprofitable company in a well-diversified basket of securities. How different in terms of sector exposure are the mid-caps from the S &P 500? I mean, just going back to the tech example, they're quite different. So you have only roughly 10 % in broad-based tech, where you have 30 % in large caps. But you have more of a, I would say, representative basket of stocks to how the American economy functions. You have higher weight to industrials, higher weight to consumer staples and consumer discretionary.

18:46So I think there are more mid-cap sectors with over 10 % than there are within S &P 500. It just shows a little bit more diversity where you're not so biased to tech and tech plus with communication services. How sensitive is this basket? I know it's a broad basket, but is there any difference between how sensitive you would expect them to be versus interest rates and inflation and the macro headwinds versus either small or large stocks? So in a period like 2022, they did fall quite significantly because ultimately their financing rates sometimes are more floating. based on how they can receive capital.

19:27So in relationship to interest rates, they probably would be a little bit more sensitive. But in terms of the order of magnitude, I wouldn't say it's that far different as it relates to, say, large caps. I think this comes back down to some of the sector biases where you do have industrials, financials, consumer discretionary, all above 10 % weights. And financials are going to be far more rate sensitive than any other sector. So you can get some bias there. but I wouldn't say it's going to be a major driver of returns. I wouldn't be buying mid-caps based on rates. How often is the index reconstituted?

20:02Is it the kind of thing where, because I know a lot of quantitative strategies, if you hit a certain threshold, a floor or ceiling, you get booted out right away. Is this an annual reconstitution like the S &P 500? Yeah. So we always get that question about reconstitution and then rebalancing. So there's that annual big bang, annual reconstitution in September, and then the sort of quarterly maintenance rebalances that take place. So it's not like the Russell recon, which, you know, everything sort of hits in one day. This, you do get the annual reconstitution where all the rules get reset and relooked at, but then they have the quarterly rebalance where things are sort of tossed back into their appropriate weights.

20:37So you mentioned that there's money flowing out of small caps, money flowing into big caps. I know this is just a short term, but this year, is there any other trends that are kind of surprising to or things that you see? Like, is there a bunch of money flowing into foreign stocks? Because obviously, you never know. These things could be some mean reversion, but these trends have to start somewhere. So any big trends that you're seeing that are happening with the flows this year? You know, I would say when we were looking at flows up until March, it was very still heavy US. I think 91 % of all the flows into equity ETFs went into US equity exposures.

21:15So that's a sizable amount of capital going in there. Basically, everyone, if you're buying equities, you're just buying US. And then we started to see more exposures go to, say, Europe, European country-based ETFs. And I think that coincided with some of the tariffs, right? The tariffs were coming out and they were starting to get a feeling that they might be more onerous than originally planned or what might be planned and more uncertainty. But we did know that Germany, for instance, is going to unleash a fiscal bazooka, I think is what they refer to it. That supported European markets. And now all of a sudden you have expanding fiscal policy overseas.

21:52Here, what we've heard from the Treasury Secretary is a debt detox. That's not really going to be that positive for equities, given how they've been able to benefit off of the levered balance sheet of the U.S. government. So all of a sudden, what do we see in March? Six billion go into Europe. and that's the second most on record for any month for European style of exposures. So we have seen a broadening from that perspective. And that just goes back to one of the earlier questions of like, how do I solve for the massive amount of concentration that I have in my portfolio? So that everyone's levered up to the gills in terms of US equities.

22:26How do I stay in US equities? How do I balance it out? How do I be more geographically balanced? And we're starting to see that come through in some of your flows. So you're the head of ETF research. So I want to get your take just building on that. Balthunas tweeted, US-focused ETF inflows have obliterated any other Q1 with$137 billion worth of inflows. 85 % of all flows. Kind of wild. So he said, ex-US ETF haul has actually been below average. So it seems to be like a mismatch between the headlines and maybe the reality. Or is it just the fact that – what do you think is going on here? Well, to Eric's tweet or X, I don't know what the hell they call it these days, the kids call them.

23:10But he's talking about on a year-to-date basis. Year-to-date, he's 100 % correct. Like, it's still very U.S. equity sensitive. I think, you know, it's 143 billion out of 176 have gone into U.S. equity exposures year-to-date, which I'm not going to do quick math again because I probably can't be right twice. But that's 82%. But that accounts for where January and February were so US equity sensitive. Now you have Europe starting to take in a little bit more. So European ETFs, again, these are things like, you know, focus on Eurostoxx50. Their flows as a percent of start of month assets, so organic growth, was 9%.

23:49US was 0.76%. So US is just huge. So their numbers are always going to be big. But on a relative to asset basis, you're starting to see people step back into Europe. What are you all seeing on the fixed income side? There was just a never-ending parade of money going into longer-dated or longer-duration bonds. And I guess the thinking was that the Fed was done raising rates. Inflation was behind us. And so you got the double whammy of either recession risk rates falling or the Fed cutting rates. Both of those, at least one of those seems to be off the table, the Fed cutting. but how are investors thinking about the risk of a recession, lower rates, combined with the risk of higher prices, higher inflation, and higher rates?