In recent times, most of the stock market’s gains have accrued to megacap growth and AI stocks. Other areas of the market have struggled to keep up. But with the economy still chugging along, mid-cap stocks might be the beneficiaries of the next leg of the rally.
Many people probably wouldn’t realize it, given their relative returns over the past several years, but mid caps have actually outperformed large caps over the long term. Since 1991, the mid-cap-focused S&P 400 index has gained 2,679% while the large-cap-focused S&P 500 rose by 2,021%. Given how long large caps have been leading the market lately, a reversion to the mean could juice mid-caps’ returns even more.
If economic growth remains firm, inflation stays under control, and investors look for opportunities beyond the market’s recent winners, mid-cap ETFs could realistically deliver returns of roughly 11% annually over the next few years. Here are three mid-cap ETFs I’m thinking about right now.
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If you just want broad mid-cap exposure, the iShares Core S&P Mid-Cap ETF(NYSEMKT: IJH) should be your first stop.
Tracking the S&P 400 index, it’s currently the largest mid-cap core ETF on the market — even bigger than the Vanguard Mid-Cap ETF(NYSEMKT: VO). It charges annual fees of just 0.05% and also has the benefit of adding only profitable companies. That gives it a built-in tilt toward quality that other mid-cap funds might not offer.
Its biggest three sector exposures are industrials (19.3%), consumer discretionary (15.3%), and financials (13.6%). This is a much different mix than you’ll find in the S&P 500, which makes it great for portfolio diversification and added growth potential.
If the companies in those three sectors can, on average, grow their revenue by at least a mid-single-digit percentage rate, maintain their valuation multiples, and strengthen their margins, a 35% total return for the iShares Core S&P Mid-Cap ETF over the next three years seems reasonable.
The Vanguard Mid-Cap Value ETF(NYSEMKT: VOE) measures stocks according to several valuation metrics, including price-to-earnings ratio and price-to-book ratio, helping to ensure true value exposure. The qualifying components are also weighted according to their “value composite,” so there’s little to no style drift either.
If fundamentals for mid-caps improve, value stocks will be set up nicely to outperform. Not only is there a built-in discount, financials and industrials, which are the fund’s two largest sector allocations, tend to benefit the most during periods of economic acceleration.
It’s worth remembering that improving growth tends to help cyclical value stocks. If investors rotate away from crowded growth stocks and market breadth improves, mid-cap value stocks could benefit from that tailwind.
If mid-caps having a modestly higher risk profile than large-caps concerns you, going with a fund that features a quality tilt can make a lot of sense. Avoiding some of the questionable names in this group can help reduce your downside risk without sacrificing too much upside.
The Invesco S&P MidCap Quality ETF(NYSEMKT: XMHQ) screens its potential holdings by several fundamental factors, such as return-on-equity (ROE) and financial leverage. The result is a more concentrated portfolio of around 80 stocks. Because it only owns companies with more consistent earnings and healthier balance sheets, its returns should be somewhat cushioned if broader economic conditions head south.
When volatility picks up, quality tends to hold up better than pure mid-cap beta exposure. That can help returns compound over time and improve risk/reward ratios.
Each of these three ETFs offers a different way to invest in mid-caps, but the outlook for the entire group remains positive. Earnings growth has been good, lower interest rates should add a tailwind to share prices, and their valuations are much more attractive than those of large caps. That could prove to be a winning combination over the next several years.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Index Funds-Vanguard Mid-Cap ETF. The Motley Fool has a disclosure policy.
