CHICAGO (Reuters) - Like the middle children they are, mid-cap stocks are often outshined by their mega-cap brethren. The largest two constituents of the S&P 400 Mid-cap Index are Regeneron Pharmaceuticals Inc and Equinix Inc, an information technology firm. Not exactly Apple Inc or Johnson & Johnson.
Yet inattention from the investing world often misses that fact that mid-caps often outperform large companies and are worthy additions to any portfolio. These are generally companies with a market value of from $1 billion to $4 billion but with an outer range of about $13 billion,
Take Ametek Inc, a $9 billion company, which produces electronic instruments for the aerospace industry. It rarely makes headlines, but the company hit a 52-week high on January 4. Overall, the S&P mid-cap index was up almost 4 percent year-to-date through January 11, compared to 3.2-percent return for the large-cap S&P 500 Index over the same period.
Mid-caps tend to prosper because of their flexibility to grow earnings and acquire companies away from the constant glare of analysts and financial media. Institutional investors also tend to shift their purchasing to mid- and small-cap stocks as a bull market matures.
An even better reason to consider mid-caps is their performance long-term when compared to the large-cap S&P 500 Index. Standard and Poor’s did a study of their mid-cap 400 index that covered the period from July 1991 through December 2011 that found that mid-sized companies posted an average return of 1.04 percent, vs. 0.75 percent for the large-cap index.
On a risk-adjusted basis, the mid-cap performance was 50 percent better as measured by the Sharpe Ratio, which measures reward against the amount of risk taken. The only downside for mid-caps during that period was standard deviation. Mid-caps were more than 2 percentage points higher in volatility.
Breaking the S&P numbers down into smaller slices, mid-caps bested larger stocks over three-, five-, ten- and 15-year periods. The mid-cap advantage was as high as 4 percentage points in the study.
Since there are six major indexes to choose from when investing, it’s hard to nail down which exchange-traded index funds to pick. To add to the confusion, each index defines a mid-cap stock slightly differently.
Writing in Seeking Alpha, investing analyst Kurt Shrout examined the difference in returns over time for and discovered that the S&P 400 and Russell Mid-cap were the best-performing indexes from 1983 through 2011 (see link.reuters.com/jab35t). Note: Newer indexes weren't based on as much performance information.
The principal ETF tracking the S&P 400 index is the iShares Core S&P Mid-CAP ETF, which contains Regeneron and Ametek, and also Church & Dwight Co Inc, a maker of baking soda, and Kansas City Southern, a railroad. The fund was up about 4 percent for the year through January 11 and rose almost 18 percent last year, outperforming the S&P 500 by 2 percentage points in total return.
A worthy alternative to the iShares fund is the Vanguard Mid-Cap ETF, which had been tracking the MSCI Mid-Cap index, but will switch over to an index prepared by the Center for Research in Securities Prices later this year. The fund returned 16 percent over the past year.
The one caveat with mid-caps is that they will increase your portfolio’s risk profile. And they are certainly not immune from market declines, as evidenced in 2008: The iShares fund lost 36 percent of its value in that year, just a point less than the larger index.
Mid-caps also introduce some industry concentration risk. When you look at the pie chart for the S&P Mid-Cap Index, nearly one-quarter of it is invested in financial companies, 17 percent in industrials and 15 percent in information technology. While that mix will respond well to a growing economy, the opposite is true when things slow down.
Consider mid-caps as part of your overall stock allocation, perhaps up to 10 percent. They are best suited for longer-term investors who like their risk-return profiles, yet who are not overly concerned with owning brand-name stocks that may not make the financial headlines.