Why We’ve Added Mid Caps to Your Portfolios

Timothy GroveApril 15, 2016


Why has HFA added mid cap stocks to my portfolio?  This is a question that many of our clients have likely been asking over the past year or so.  At HFA, our clients know that we do not engage in market timing or short-term performance chasing as we believe that these are not likely to be conducive to investment success.  Rather, we take a long-term “buy-and-hold” view and believe that maintaining an asset allocation that is appropriate for each client’s goals and rebalancing to that allocation when necessary provides the best potential for success.

However, it is imperative to stress that “buy-and-hold” does not mean “buy-and-forget”, nor should it be construed as complacency in our investment methodology.  As already noted, we continuously monitor the asset allocations of all our clients’ portfolios relative to their targets and rebalance to those targets as needed.  This necessarily causes us to “sell high and buy low”-a proven investment process. We also keep a very close watch on the funds we use not only for performance but for any organizational or managerial changes and for any deviation from their stated investment discipline.  We meet with the fund managers to discuss our concerns and replace a fund if we are convinced that it is no longer helping to maximize the potential for the long-run success of our clients.  While we do not make decisions based on short-term performance, we are always on the lookout for new ways to potentially improve the long-term performance of our clients’ assets.

Once in a while, after thorough and rigorous analysis and research, we will, on a firm-wide level, make a change to the sub-asset class allocations in our model portfolios, even adding or removing an entire sub-asset class.  This has been the case over the past year with regard to the addition of a dedicated allocation to U.S. mid cap stocks (stocks with a market capitalization of about $2 billion to $10 billion) to our model portfolios and a corresponding reduction to the allocation to U.S. large cap stocks.

There are several very compelling reasons why we felt this was a necessary move.  The first and most obvious is the absolute performance (total return) of U.S. mid cap stocks vs. both U.S. large and small cap stocks.  While past performance does not guarantee future results, the annualized total return for U.S. mid cap stocks (as measured by the S&P MidCap 400 Index) for the 20-year period ending 12/31/15 was 11.2%, vs. 10.1% for U.S. small caps (as measured by the S&P Small Cap 600 Index) and 8.2% for U.S. large cap stocks (as measured by the S&P 500).  Mid caps have also fared very well in numerous rolling periods and also have not been hit as hard as small caps in market downturns but have recovered faster than large caps in market recoveries.  Mid caps also have had very attractive risk-adjusted performance; they have provided excellent levels of return for the amount of volatility they have exhibited.

Mid cap companies are those with market capitalizations (the total value of the company’s stock) in the range of about $2 billion to $10 billion.  These companies have an advantage over small cap companies in that they are further along in their growth and are therefore more stable and less vulnerable to economic shocks than small caps.  When compared to large cap companies, mid caps are more nimble and have greater growth potential; mature large cap companies, while more stable, have difficulty finding additional growth opportunities.  Mid cap companies also tend to be attractive buyout targets for mature large cap companies seeking to grow through acquisitions.  Often, this is the only way for mature companies to grow so they are likely to overpay, which is another advantage to mid caps.  Finally, mid cap stocks are not widely followed by analysts and investors as a whole tend to underweight them (as compared to their weighting in the stock market) so the market for mid cap stocks is relatively “inefficient”, meaning that active managers who specialize in mid cap stocks are more likely to find overlooked “gems”.

Investors often make the mistake of thinking that, by investing in both large caps and small caps, they will have an adequate allocation to mid caps due to the overlap between the two.  In truth, the exposure to mid caps should be obtained with funds and managers that specialize in mid caps.  As was noted previously, there is substantial inefficiency in the mid cap space so it takes a manager who is able to navigate this area to find opportunities.  One also has to take care to use funds that are true mid cap funds and not just funds that fall into the mid cap category as a result of some artificiality.  Examples of this are “all-cap” funds that average out to be mid caps, or small cap funds whose asset base has become too large.  At HFA, we are careful to use true mid cap funds for the allocation to this area.

Mid caps are often called the “sweet spot” of the market, and with good reason, but they are largely overlooked by the investing community.  While past performance cannot predict future results (and it is therefore most prudent to maintain a broadly diversified allocation to all types of stocks) we at HFA believe that the addition of a dedicated allocation to mid cap stocks in a long-term investment strategy will increase the chances of our clients achieving their financial goals.



The Power of Mid-Caps: Investing in a “Sweet Spot” of the Market

Why Mid Caps?

The Mid-Cap Equity Opportunity

Why Investors Should Look To Mid-Cap Stocks

Mid-Cap Stocks: Opportunities in the Heart of the Market