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The Case for a Dedicated Allocation to Mid Caps

20 December 2023   |  

In our previous blog post “Narrow Leadership Creates Opportunity”, we highlighted the attractive valuations of US mid-cap stocks, which are at their cheapest levels relative to large caps in over 20 years. As value investors, we distinctly understand the importance of starting-point valuations for forward returns, however you don’t have to be a value investor to appreciate the asset class’s appeal.

Since 1979, the Russell Midcap® Index has outperformed both the Russell 1000® and 2000® indices (Exhibit 1) on an annualized basis by 0.8 percentage points and 1.9 percentage points, respectively. While that may seem small, the power of compounding can result in large differences as one’s time horizon expands. For example, an investment in the Russell® Midcap Index made on January 1, 1979, would have grown to nearly 40% more than an equal investment in the Russell 1000® Index.

Exhibit 1: Historical Outperformance Delivered by Mid-Cap Equities

Source: FactSet/Artisan Partners. As of 30 Sep 2023. Past performance is not indicative of future results.

These cumulative returns are even more remarkable considering that large caps have trounced mid caps over the past five years, with a 9.6% annualized return versus 6.4% (Exhibit 2). Historical risk-adjusted returns are also attractive. Mid caps have been less volatile than small caps and have had similar risk-adjusted returns to those of large caps over long timeframes.

Exhibit 2: Historical Performance Trends

Source: FactSet/Artisan Partners. As of 30 Sep 2023. Past performance is not indicative of future results.

How Much Mid-Cap Exposure Do You Really Have?

However, you may have less exposure to mid caps than you think. Because broad-based US equity indices like the S&P 500® Index and Russell 1000® Index are market-cap weighted, their returns are dominated by the largest stocks. This is even more true in late 2023 given the YTD dominance of the “Magnificent 7” (Mag7) stocks. FTSE Russell employs a modular index construction, defining the Russell Midcap® Index as the smallest 800 companies in the Russell 1000® Index. Due to being market-cap weighted, the largest 200 companies represent 78% of the Russell 1000® Index. In the S&P 500® Index, the Mag7 stocks alone account for a 29% weighting—an all-time high going back over 40 years (Exhibit 3).

Exhibit 3: Market Concentration at All-Time Highs

Source: Goldman Sachs/Artisan Partners. As of 30 Nov 2023. Shaded bars indicate US recessions.

Investors in actively managed equity strategies may also be underexposed to mid-cap stocks. Some allocators are choosing to simplify their manager lineups. Rather than have a dedicated allocation with a mid-cap manager, they instead pair a large-cap manager with a small-cap manager to get their mid-cap exposure. There’s a belief that large-cap managers tend to come down in market cap relative to the large-cap benchmark indices, while small-cap managers frequently go up in market cap. However, this view may be wishful thinking. The average large cap core strategy has a weighted average market cap over $400bn compared to less than $40bn for the average mid cap core strategy (Exhibit 4). Likewise, there’s also a sizable gap in market capitalizations between small-cap and mid-cap strategies. The average small cap core strategy’s market cap is just $4bn, or $33bn less than the average mid cap core strategy.

Exhibit 4: Market Capitalizations by Asset Class for Active Strategies

Source: eVestment/Artisan Partners. As of 30 Sep 2023. Categories defined by eVestment.

Due to index market-cap weightings, the outsized YTD gains of the Mag7 stocks and the trend toward simplified manager lineups, investors may not have as much mid-cap exposure as they think. For these reasons, we believe there is a case for having a dedicated allocation to US mid caps—an asset class that has historically delivered attractive long-term risk and return characteristics. Given today’s highly attractive relative valuations, we also pose the question, “if not now, then when?”

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