Large-Caps vs. Small-Caps? Mid-Caps Are Actually The Sweet Spot For Investors

Over the past 50 years, mid-caps have produced better risk-adjusted returns and it's the profitability factor that's been driving it.

When investors talk about which equity asset class they should be investing in, the debate is usually between large-caps and small-caps. Large-caps, of course, are the big, mature, well-established companies with more durable cash flows. Small-caps are the emerging companies that are more unpredictable, but have a great deal of growth potential. Traditional portfolio allocation would suggest you own both groups in some form or fashion, but that leaves a very important group out of the discussion altogether - mid-caps.

Why Invest in Mid-Caps?

Mid-caps could be considered the happy medium between the other two categories. They’re less speculative than their smaller counterparts and stand on a firmer financial footing, but are, in many cases, still in the growth stage. If your preference is the S&P 500, think of investing in mid-caps as catching these names before they graduate into the index.

Of course, not all of them will make it to large-cap status and some will inevitably fail along the way, but there’s a great deal of potential here in this group that often goes unrealized and underappreciated by investors. In fact, history shows that it could be the more optimal choice for your portfolio.

Examples of Mid-Cap Stocks

The kinds of stocks held in mid-cap ETFs might not be as recognizable as Coca-Cola, Microsoft or Walmart, but it would be wrong to say that they’re obscure names. In fact, there are a lot of products manufactured by these companies that you may use in your everyday life! Such as…

• Five Below - This is the retailer that’s sort of like a dollar store, but specializes in selling more of the “fun stuff” that appeals to youth and teenagers.

• Deckers Outdoor - You might know them better as the company that makes Uggs and Teva sandals.

• Hubbell - This company specializes in electrical, utility and telecommunications equipment and operates brands, including Bryant, Acme Electric, Reliaguard and Wirecon.

• Cintas - There’s probably at least a couple of Cintas products in your workplace no matter what the job is. They manufacture uniforms, mops, cleaning supplies, first aid kits and fire extinguishers.

• Nucor - The largest steel manufacturer in the United States.

• Motorola Solutions - They spun off their mobile phone business into a separate company more than a decade ago, but this company is still heavily involved in telecommunications equipment, software solutions and infrastructure.

How Mid-Caps Have Performed vs. Large-Caps and Small-Caps

On the risk/return scale, it would be logical to assume that mid-caps have fallen somewhere between large-caps and small-caps with respect to both factors. Using Portfolio Visualizer, we’re able to look at returns and risk for the three asset classes over the past 50 years. The actual results have generally been in line with what’s been expected, but there have been some modestly interesting outcomes when looking over that history.

In terms of risk, we get the results we’d mostly expect. Small-caps have been about 10-15% more volatile than mid-caps, which have in turn been about 10-15% more volatile than large-caps. Mid-caps, however, had a worse single-worst year and slightly bigger drawdown.

Over the past 50 years, mid-caps actually outperformed both large-caps and small-caps. The last 10-15 years were likely the tiebreaker in favor of mid-caps. Ever since the financial crisis when the Fed severely loosened monetary conditions, there’s been a larger company bias that have pushed small-caps to persistently underperform. While mid-caps slightly underperformed the S&P 500 during that period, there was enough juice to allow them to stay ahead of small-caps on a total return basis.

Risk-adjusted returns, as measured by the Sharpe and Sortino ratios, also favor mid-caps over the long-term.

When we break it down to the factors that are driving historical returns, I see one particular result that I didn’t necessarily expect.

Note: Factor results for the indexes themselves weren’t available, so I used the SPDR ETFs as a proxy. The downside is that they only go back 18 years, but it’s still useful enough to provide some informed conclusions.

The small-cap factor (SMB or “small minus big”) obviously shows up more in SLY, but there’s a fairly significant factor loading for MDY as well. The value factor (HML or “high minus low”) also shows up much more in SLY and MDY. This can be seen pretty clearly just by looking at the current P/E ratios of each.

The profitability factor (RMW or “robust minus weak”) is interesting. Profitability is actually a bigger factor for mid-caps than large-caps. You’d generally expect the more mature nature of large-caps to drive greater profitability, but it’s actually the mid-cap group that does a better job on a relative basis.

It’s curious how this might play out in the current environment. If we’re truly heading into a recessionary environment sometime over the next 12 months, companies with greater balance sheet quality tend to outperform. Does that mean mid-caps might actually stand a good chance of holding up in such an environment?

This exercise is obviously a backward-looking view and isn’t meant to predict what’s going to happen going forward, but it does demonstrate pretty clearly that mid-cap stocks shouldn’t be ignored. They could be the ideal choice for striking the right balance between growth and durability.

Best ETF Choices For Investing In Mid-Caps

Mid-Cap Blend

• iShares Core S&P Mid-Cap ETF (IJH)

• Vanguard Mid-Cap ETF (VO)

• iShares Russell MidCap ETF (IWR)

• SPDR S&P MidCap 400 ETF (MDY)

Mid-Cap Growth

• iShares Russell Mid-Cap Growth ETF (IWP)

• Vanguard Mid-Cap Growth ETF (VOT)

• SPDR S&P 400 Mid-Cap Growth ETF (MDYG)

Mid-Cap Value

• Vanguard Mid-Cap Value ETF (VOE)

• iShares Russell Mid-Cap Value ETF (IWS)

• SPDR S&P 400 Mid-Cap Value ETF (MDYV)