The SPDR Mid-Cap 400 (NYSEArca: MDY) and rival mid-cap exchange traded funds often generate better returns and than rival large- and small-cap ETFs and a lot of that has to do with the sector mix of the benchmark mid-cap index.

MDY tracks the widely followed S&P MidCap 400 Index. Over a long-term horizon, though, mid-caps have outshined the competition. Since 1996, the S&P MidCap 400 generated an average annual return of 10.4%, compared to 7.3% for the S&P 500 and 9.7% for the SmallCap 600.

Currently, MDY, one of the largest mid-cap ETFs, allocates nearly half its combined weight to the financial services, industrial and technology sectors.

“While sector allocations contributed to the S&P MidCap 400’s excess returns in 2000, the performance of mid-cap I.T. stocks also helped: the mid-cap benchmark’s Information Technology sector fell 4.7% in 2000 compared to a 40.9% plunge by the corresponding S&P 500 sector,” said S&P Dow Jones Indices in a recent note. “So which effect was more important in explaining the mid-cap index’s outperformance – its sectoral allocations or the selection of stocks within each sector?”

Marvelous Mid Caps

The mid-cap category has also outperformed their larger peers, but with lower volatility than small caps. Moreover, the returns of mid-cap stocks have also beaten those of small-cap stocks during the trailing three-, five-, and 10-year periods, with lower volatility.

“The hypothetical ‘sector match’ portfolio combines the capitalization-weighted S&P 500 sector indices in proportions that match the mid-cap index’s sector weights,” notes S&P Dow Jones.

The $19.74 billion MDY devotes about 34% of its combined weight to the consumer discretionary, real estate and healthcare sectors.

Mid-cap companies are slightly more diversified than their small-cap peers, which allows many mid-sized companies to generate more consistent revenue and cash flow, along with providing more stable stock prices. Additionally, they are not so big that their size would slow down growth. Increased mergers and acquisitions activity could be just what mid-caps need to catch up to large- and small-cap stocks.

“The relative importance of stock selection suggests that mid-cap companies may possess a strategic advantage relative to firms within different size ranges,” according to S&P Dow Jones. “Indeed, mid-caps have generally overcome the risks of small-cap companies while remaining nimble enough to take advantage of growth opportunities that may be unavailable to their large-cap counterparts.  As a result, market participants may wish to consider the potential applications of an index-based allocation to U.S. mid-cap equities.”

For more information on middle capitalization stocks, visit our mid-cap category.

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