Mid-cap stocks could produce healthy growth this year as the economy continues to recover from the global pandemic and gain from inflationary measures and the falling U.S. dollar.
Investors who want to diversify away from the tech titan large caps should consider overlooked opportunities in midcaps, says Mike Loewengart, managing director of investment strategy at E-Trade Financial, an Arlington, Virginia-based brokerage company.
“Midcaps can serve as a cross between the two asset classes — offering more stability but less upside than small caps, and potentially greater growth potential but added volatility compared to large caps,” he says. Here are some things to keep in mind about midcaps:
— Market factors have changed.
— How midcaps perform after a downturn.
— Mid-cap stocks increase diversification.
Market Factors Have Changed
Now that the stock market has recovered from March 2020 lows, investors may want to reconsider their strategies. During the recovery, small caps outperformed both large caps and midcaps. That dynamic has changed.
“We’ve recently seen investors return to a familiar playbook and pursue large-cap and megatech stock names, while shying away from small caps in an environment where returns have become harder to come by,” Loewengart says. “While a number of factors can play into that rotation, there’s a middle ground between large and small that often goes overlooked — midcaps.”
Investors who want to reap the gains of the current economic growth cycle should consider the mid-cap sector.
Market growth influences which companies qualify as midcaps. S&P Dow Jones Indices updates the requirements for large-, medium- and small-cap companies quarterly. The most recent update in June increased the requirement for inclusion in the S&P 500 to $13.1 billion or more in market capitalization, $3.6 billion to $13.1 billion for the S&P MidCap 400 and $850 million to $3.6 billion for the S&P SmallCap 600.
“Mid-cap stocks represent one of the best ways to benefit from the economic recovery that’s unfolding in the U.S.,” says Emily Roland, co-chief investment strategist at John Hancock Investment Management, a Boston-based investment company.
How Midcaps Perform After a Downturn
Midcaps are often overlooked by investors even though their outperformance can last for several years after a recovery.
“While both small- and mid-cap equities tend to outperform large caps early in the cycle when risk-taking is most rewarded, small caps tend to see their biggest bounce in the initial stage of the rebound,” she says.
After the early 2000s recession, mid-cap equities outperformed large caps for three consecutive years — 2003 through 2005, Roland says.
“Similarly, midcaps performed well after the global financial crisis, beating large caps four out of five years from 2009 through 2013,” she says. “After underperforming large caps for the past six years from 2014 to 2020, midcaps may be an overlooked part of the market today.”
Midcaps perform well during periods of economic expansion and are an asset that protects investors from the impact of inflation, Loewengart says. The performance of midcaps is also historically less volatile than small caps. Since midcaps focus their operations domestically, they are more immune from trade-related and geopolitical issues, he says.
From 1966 through 2018, mid-cap stocks generated various returns during several monetary policy conditions. When the Federal Reserve lowered interest rates or pursued an expansive monetary policy, the return of midcaps was 22.9% annually from 1966 through 2018, says Robert Johnson, a finance professor at Creighton University’s Heider College of Business in Omaha, Nebraska.
However, when the central bankers followed an indeterminate monetary policy where interest rates neither rose nor fell, the return of midcaps was 12.4%. The lowest rate of return of midcaps, 5.5%, occurred when the Fed sought a restrictive monetary policy or when rates rose, he says.
Mid-cap Stocks Increase Diversification
Mid-cap stocks can serve as a ballast to a portfolio in a low interest rate environment since cheaper financing can fuel a company’s growth path, Loewengart says.
“With potentially more room to run compared to large caps, they can outpace inflation,” he says.
Investing in midcaps can add a layer of diversification to a portfolio. A straightforward way to invest is through mid-cap exchange-traded funds such as Vanguard Mid-Cap ETF (ticker: VO), Loewengart says.
“ETFs take the heavy lifting out of investment selection with a typically low cost basis,” he says. “Before investing though, do your homework and make sure the fund objectives match your risk tolerance, long-term goals and time horizon.”
VO is a good addition to a portfolio since the ETF uses an indexing investment approach that tracks the performance of the CRSP US Mid Cap Index, a broad index of stocks featuring mid-sized U.S. companies, Johnson says. The fund charges a low expense ratio of 0.04% and has one- and three-year returns of about 39% and 16%, respectively. The ETF also has a five-star rating from Morningstar, a Chicago-based research investment firm.
The combination of earnings growth potential, stability, income generation and the ability to withstand volatility in the market makes midcaps a good addition, says Todd Rosenbluth, head of ETF and mutual fund research at CFRA Research, a New York-based finance research company.
Investors should also consider adding the iShares Core S&P Mid-Cap ETF ( IJH), which has a one-year return of 43% and a three-year return of 11%. The fund has a reasonable 0.05% expense ratio. For people seeking exposure to midcaps with an income component, the ProShares S&P MidCap 400 Dividend Aristocrats ETF ( REGL) is another alternative since it only includes companies that have raised dividends for 15 consecutive years.
A key feature of mid-cap equities is their outsize exposure to the industrial sector, Roland says. “Industrials are expected to see strong earnings growth in 2022, benefiting from the improving economic backdrop as well as increased spending on infrastructure,” she says. “Unlike other cyclical sectors like financials and energy, industrials don’t need higher rates in order to show market leadership.”
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Update 08/24/21: This story was published at an earlier date and has been updated with new information.