ETF Focus: Not Too Large, Not Too Small: A Midcap ETF Strategy Might Be Just Right

Not too large, not too small, but just right.

Just like Goldilocks trying out the three bears’ chairs, investors may find a “just right” strategy in between “large” and the “small” alternatives, according to recent research from fund analysts.

Midcap stocks, and the exchange-traded funds that contain them, may fly under the radar as investors view large-cap stocks as more stable and familiar, while small caps offer the prospect of heady growth. But as Matthew Bartolini, head of SPDR Americas Research, argues in a September research note, midcaps split the difference.

“Large-cap stocks offer the stability that comes with mature multinational businesses with diverse revenue sources,” Bartolini said. “Small-cap stocks are unproven, but they offer potential for further expansion and market penetration. And midcaps offer a unique combination of the managerial maturity associated with large caps and the operational dexterity of small caps.”

That’s not just a hypothesis. Bartolini notes that midcap companies have historically had lower leverage than large caps, while enjoying margins that are in between large- and small-cap companies. Over the past two decades, they’ve had a 7% higher growth rate than large caps, and 32% less earnings volatility than small ones.

Meanwhile, ETFs that track indexes are increasingly being used as investing strategies in and of themselves, and many investors are looking at size as a factor in allocating funds, points out Todd Rosenbluth, head of fund research at CFRA.

Related: Here’s how to get ‘smart’ about factors

More money is allocated to large-cap strategies — $6.7 trillion — and small caps — $825 billion — than midcaps, which has only captured $872 billion, Bartolini noted. And Rosenbluth has a tally of mutual funds: only 289 focused on midcaps, compared with 525 focused on small caps and 784 on large.

That may be because the investment thesis for large- and small-cap strategies is more obvious, but it may also be because active midcap managers have underperformed.

See: Welcome to the adult table: SEC sets new ETF rules

Less than one-third of active midcap managers have beaten their benchmark over multiple time horizons, Bartolini wrote. While he doesn’t explain why, he does note that there are twice as many Wall Street analysts covering large-cap stocks as covering midcaps, and a survey of academic literature reveals six times as many research papers written about “small cap” or “small stocks” compared to “mid cap” or “mid cap stocks.”

Whatever the reason, the track record of active managers, and their higher fees — about 98 basis points compared to less than half that for index-fund fees — make a passive approach more appealing, Bartolini wrote.

One such index fund, SPDR’s S&P Midcap 400 ETF MDY, +0.62%  , has returned 14.23% in the year to date, according to FactSet, beating the Dow Jones Industrial Average DJIA, +0.57% return of 13.91%, but lagging that of the S&P 500 SPX, +0.64%  .

Related: In investing, it’s better to think big picture

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