Given the developed world's political and debt problems, plodding economic growth is expected for much of the year. To that end, investors have upped their allocations to large cap value or dividend paying stocks as a way to navigate the sideways market. Funds like the Vanguard Dividend Appreciation ETF (ARCA:VIG) have surged in popularity as the trend has taken hold. While there's no denying the appeal of these sorts of funds or their place in a portfolio, those investors looking for a little more "oomph" might be suited in another market sector.
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The Market's Sweet Spot
For those investors looking for better growth opportunities than what large-cap stocks can offer, but minus the extreme volatility that plagues small-cap stocks, the often overlooked mid-cap space could exactly what a portfolio needs. Defined as companies with market caps between $2 billion and $10 billion, they provide the right mixture of attributes for a slow moving market. These firms have plenty of advantages over their smaller sisters including seasoned management teams, better IT infrastructures, broader and sometimes global distribution channels and easier access to capital markets. This provides stability within their organizations. However, unlike large-cap giants, mid caps still offer plenty of growth opportunities as they mature. Room for multiple expansions, less overall bureaucracy and generally more entrepreneurial spirit helps drive mid-cap growth.
Being in the markets sweet spot certainly has its advantages when it comes to outperformance. Over the last 20 years, mid caps have outperformed both their larger and smaller sisters by a wide margin. The iShares Russell Midcap Index (ARCA:IWR) has produced a roughly 10% annual return in that time frame. That dwarfs the annual performance of its more small-cap sister, the Russell 2000 (ARCA:IWM) by nearly three percentage points. In addition, mid caps have produced these higher returns without adding much in the way of volatility. According to data provided by FactSet, mid-cap stocks have "historically offered a favorable risk/reward tradeoff versus both large- and small-cap stocks."
Finally, that growth could continue into the future as merger fever has taken hold of the market. With a variety of larger firms now flushed with cash and starving for organic growth, merger and acquisition (M&A) activity has gone up considerably. Between 1995 and 2011, more than 27% of the M&A deals have involved mid-cap companies. By purchasing mid caps, larger firms gain instant access to new products and customers, add economies of scale and obtain valuable intellectual property. Given that firms within the S&P 500 are sitting on nearly $1.7 trillion in cash earning nothing, merger activity will certainly expand and mid caps will directly benefit. For related reading, see Key Players In Mergers And Acquisitions.
Given mid caps' strong growth prospects and stability, they could be exactly what investors need in this sideways market. There are plenty of household names in the sector such as burger joint Wendy's (Nasdaq:WEN) and consumer products firm Church & Dwight (NYSE:CHD) that investors may be familiar with. However, the space may be navigated through a broad basket approach. Exchange traded funds (ETFs) allow investors to bet on a wide swath of the firms within one ticker. Here are a few picks.
With nearly $11 billion in assets and a daily trading volume of 2.5 million shares, the SPDR S&P MidCap 400 (ARCA:MDY) is the mother of all mid-cap ETFs. The fund tracks 400 different mid-cap stocks, like Monster Beverage Corp (Nasdaq:MNST) and has managed to produce an 11.85% annual return since its inception in 1995. The fund charges a rock bottom expense ratio of 0.25%. Likewise, the Vanguard Mid-Cap ETF (ARCA:VO) charges a dirt cheap 0.12% in expenses.
Like their large-cap cousins, mid caps can be a great source of dividend income. ETF sponsor WisdomTree (Nasdaq:WETF) offers two funds that investors can use to tap this fact. The WisdomTree MidCap Dividend (ARCA:DON) offers investors a 2.29% yield, and tracks high dividend paying midcaps in the United States. A better bet may be its WisdomTree International MidCap (NYSE:DIM). This ETF allows investors to take advantage of currency fluctuations and the general long-term decline of the dollar. The ETF currently yields 4%. For related reading, see 6 Popular ETF Types For Your Portfolio.
The Bottom Line
The sideways moving market and potentially low economic growth scenario, means investors may want to add mid-cap stocks to their portfolios. Featuring the right amount of growth and stability, mid caps represent a great opportunity in the current marketplace. By using ETFs like the iShares S&P MidCap 400 (ARCA:IJJ), investors can gain access to a wide swath of mid-cap firms.
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At the time of writing, Aaron Levitt did not own shares in any of the companies mentioned in this article.