When it comes to long-term index investing, a good guiding principle might be to “go medium or go home.”
Not only has the oft-overlooked asset class of mid-cap stocks substantially outperformed its large- and small-cap peers during the bull market, but over decades, it tends to generate better risk-adjusted returns, too.
Mid-cap stocks are roughly those that have a market capitalization of anywhere from $2 billion to $10 billion, but that definition gets stretched a bit when looking at the two big mid-cap benchmarks.
- The Russell Midcap Index has an average weighted market cap of $8.6 billion, and a median cap of $4.3 billion. When the index was last reconstituted, component stocks ranged in market cap from $1.4 billion to $17.4 billion.
- The S&P 400, meanwhile, skews toward companies with smaller market caps. Average and median capitalization are $2.9 billion and $2.6 billion, respectively, with individual stocks ranging in cap from $280 million to $13.2 billion.
Regardless of how you slice it, mid-caps have been putting up market-beating returns in the recent past, and the long haul as well:
(early march 2009)
So what advantages do mid-cap stocks hold?
For starters, they combine some of the best attributes of both their small-cap and large-cap peers.
Among the pluses for small-caps are that they have outsized growth prospects, if only because it’s easier to put up exponential gains against a small base. They also garner less analyst and media attention, making them more likely to be mis-priced. However, small-caps also have greater risk and volatility, greater dependance on debt and a general paucity of dividends.
Large-caps, meanwhile, have proven themselves, tend to have stronger balance sheets and have an easier time tapping capital and debt markets. They’re also more likely to pay dividends and enjoy more diversified revenue streams. However, large-cap stocks’ days of really hot growth are usually behind them.
Mid-caps sit in the happy middle.
Think of them as small-caps that succeeded — but aren’t so big as to have put their best days behind them. They benefit from having greater financial strength, liquidity and capital-raising ability than small caps, yet still fly under the radar enough to be mis-priced. And, unlike large-caps, they tend to generate greater cash flow and faster earnings growth than their stodgier, bigger peers.
Given all that, mid-caps in some ways offer the best of both worlds, which probably is why they have generated superior absolute and risk-adjusted returns over the long haul.
Indeed, in the past 20 years, the Russell Midcap generated an annualized return of more than 10%, according to Fidelity Investments. Large-caps managed annualized returns of only about 7%, while small-caps put up 8%. Perhaps most important, that same absolute outperformance still stands even after adjusting for risk.
As always, exchange-traded funds offer the greatest flexibility and lowest fees when it comes to making a diversified investment, with the Vanguard Mid-Cap ETF (NYSE:VO), iShares Russell Midcap ETF (NYSE:IWR) and iShares Core S&P Mid-Cap ETF (NYSE:IJH) offering excellent liquidity and low expense ratios.
Whatever the reasons, a strong risk-adjusted track record through market cycles argues in favor of allocating a portion of your long-term equity portfolio to mid-cap stocks.
As of this writing, Dan Burrows did not hold a position in a any of the aforementioned securities.