Middle-capitalization stocks and exchange traded funds have attracted greater interest over the years with their better risk-adjusted returns. However, investors may not want to overweight the asset category as valuations are looking pricey.
There are a number of broad mid-cap stock ETF plays that investors have looked over. For instance, the iShares Core S&P Mid-Cap ETF (NYSEArca: IJH) and SPDR S&P MidCap 400 ETF (NYSEArca: MDY) both track the S&P MidCap 400 Index, with about 69% mid-cap exposure and 31% in small-caps. [The Lengthy Out-Performance of Mid-Cap ETFs]
The Vanguard Mid-Cap ETF (NYSEArca: VO) provides an alternative as it follows the CRSP US Mid Cap Index, but the it also includes a 20.2% weight in large-caps, along with 79.0% mid-caps.
Investors can also consider the Schwab US Mid-Cap ETF (NYSEArca: SCHM), which follows the Dow Jones U.S. Mid-Cap Total Stock Market Index. The index holds 86.8% mid-caps and 10.4% small-caps.
Alternatively, there are a number of smart-beta index ETFs that tilt toward mid-cap stocks due to their indexing methodologies. For example, the Guggenheim S&P 500 Equal Weight ETF (NYSEArca: RSP) equally weights S&P 500 stock components and includes 46.7% mid-caps, 40.2% large-caps and 12.8% mega-caps.
“With higher returns than large caps but less risk than small caps, mid-caps have generated better risk-adjusted returns,” writes Morningstar analyst Michael Rawson. “But with elevated valuations, now may not be the best time to overweight mid-caps.”
Rawson points out that mid-cap stocks have experienced a near unchanging relationship between risk and excess return since 1926.
However, mid-caps are now trading at more expensive price-to-forward-earnings. Specifically, the Russell Midcap Index was trading at a 19.7 P/E at the end of March, higher than all but 18 of 444 months since 1978. The Midcap Index is also trading at a 12% premium to the 17.6 P/E of the large-cap Russell 1000 Index. Rawson noted that the mid-cap and large-cap indices have historically traded at about the same P/E ratio.
Mid-caps also have a higher debt-to-capital ratio and are less profitable than large-cap stocks, which make middle-capitalization companies more volatile and more sensitive to business cycles.
For more information on middle-capitalization stocks, visit our mid-cap category.
Max Chen contributed to this article.