Frequently defined as companies with market capitalizations between $2 billion and $20 billion, mid caps account for 35% of the roughly 3,300 publicly traded companies in the United States.1 It may therefore come as a surprise that many investors are underexposed to this sizable market segment, particularly when you consider its history of outperformance.
The overlooked and underinvested
Looked at from the perspective of a broad-based index such as the Russell 3000 Index, 19% of the opportunity set makes up mid-cap companies, but as of December 2017, investors had only 13% of their U.S. equity assets allocated to mid-cap stocks. At a roughly 6% underweight position, investors’ portfolios tend to be biased toward small- and large-cap stocks.
One reason for this may be that asset allocators—both professional advisors and robo-advising platforms—prioritize the combination of stable large-cap companies with the growth potential represented in smaller companies. By doing so, they forgo more direct allocations to midsize companies, which, as we’ll show, make up one of the more attractive segments of the U.S. equity market.
The mid-cap performance edge
Mid caps have historically grown more quickly and generated faster earnings growth than both large and small companies. In terms of the business growth cycle, mid caps have essentially proven their ability to evolve past the more fragile stages of small company growth and, in the most fertile investment cases, have yet to see their growth reach maximum velocity. Over the long term, this combination of stability and superior earnings growth potential has led mid caps to deliver stronger absolute and risk-adjusted returns relative to both small- and large-cap stocks.
Why not go all in on mid caps?
While mid-cap stocks are a compelling asset class in terms of their performance results, investing in this segment of the market doesn’t come without challenges.
First, it’s notoriously difficult to find talented investment managers in the mid-cap category. In the trailing five-year period ended December 31, 2017, only 20% of mid-cap funds beat their respective benchmarks across growth, value, and blend categories.2
Second, actively managed mid-cap funds have a recent history of tax inefficiency. Between 2015 and 2017, on average, 83% of mid-cap funds paid out capital gains. In 2017, the average distribution was nearly 8% of net asset value—a meaningful gain that may pose a substantial liability for many investors at tax time this year.3
Third, mid-cap funds don’t come cheap. The average expense ratio for a mid-cap fund is 1.11%. According to the Investment Company Institute, the average cost of actively managed mutual funds has declined substantially over the past 15 years, with the asset-weighted average expense ratio for all U.S. equity funds in 2016 registering 0.63%—almost half the cost of the average mid-cap fund. Of course, cost can be a key obstacle to outperformance—and a substantial hurdle to investors’ willingness to commit capital.
How to access the opportunity? Consider a mid-cap ETF
Given some of the challenges with active mid-cap funds, investors may do well to consider their options among mid-cap ETFs.
First, the benchmark-relative performance challenges faced by active managers aren't as severe for certain types of ETFs, particularly smart beta ETFs. Where market-cap-weighted ETFs will always at least modestly underperform the indexes they track because of fees, smart beta ETFs, which are frequently designed to emphasize factors associated with positive long-term returns, can offer investors low tracking error and the potential for modest outperformance relative to their benchmarks. As John Hancock Investment Management has shown in a recent study, smart beta may provide a more risk-controlled method of seeking outperformance in categories in which actively managed funds are particularly challenged, such as mid-cap core.
Second, ETFs can be more tax efficient than most actively managed mutual funds, given their ability to reduce taxable events. In particular, ETFs benefit from something called in-kind redemptions. In other words, brokers can create or redeem shares in kind, meaning they can exchange ETF shares for a basket of securities rather than cash. Where a mutual fund may have to sell equity positions to raise cash to meet redemptions, an ETF can avoid selling securities and so can steer clear of making capital gains distributions.
Third, ETFs can offer a substantial cost savings relative to mid-cap mutual funds. While costs vary, with market-cap-weighted ETFs offering the lowest-cost options and smart beta mid-cap ETFs offering moderately more expensive options, the discount relative to active funds can run anywhere from 50% to 90%.
Given that investing in a lower-cost vehicle from a proven manager can substantially increase the odds for outperformance, the calculus an investor must go through when considering mid-cap ETFs is made somewhat easier. In other words, tilt in the direction of the best track records among passive and smart beta options for the mid-cap category—a massive market segment in which good active results can be hard to find.
Learn more about multifactor ETF investing here.
1 FactSet, as of December 2017. 2 Morningstar Direct, as of December 2017. 3 Morningstar Direct, as of December 2017.