The U.S. equity market is the largest and deepest in the world. As such, it has been analyzed in many ways to determine the optimal means of gaining exposure. Typically, the two main ways the market is segmented are by size (small, mid, large) and investment style (core, growth, value). Focusing on size, many investors have taken a barbell approach with their U.S. equity portfolios: allocating to large cap equities on one side paired with either a small or small-mid cap (SMID cap) allocation on the other side. In this way, they get exposure to the largest, most liquid bellwether companies complemented by smaller companies, where there is typically more alpha potential for bottom-up stock pickers. While we think this is an effective approach and has proven successful for investors over the long term, we believe it can be improved upon by swapping the small or SMID cap allocation for a mid cap allocation. Despite the potentially misleading industry-wide naming convention, mid cap strategies have greater latitude to invest across the full spectrum of small and mid-cap companies as opposed to the more limited small and SMID universes. We believe a blend of U.S. mid and large caps increases the total return potential of a U.S. equity allocation thanks to a broader investable universe in the mid cap space and the flexibility to opportunistically move up and down the small and mid cap investable universe to capitalize on market dislocations. This approach can also enhance a portfolio by increasing the overall quality and liquidity characteristics, increasing the investable capacity, and reducing implementation costs.

The U.S. Is a Great Place to Invest for the Next Decade and More

Before we make the case for “why mid caps,” we shouldn’t take for granted why investors should be excited about the prospects for U.S. companies over the next decade and beyond. Some highlights include:

1. The U.S. continues to draw in the best and brightest globally to its top schools and employers.
2. The demographic profile and population growth trends are some of the healthiest amongst advanced economies.
3. The entrepreneurial energy and support network is second to none. This includes some of the best universities, the deepest and most sophisticated capital markets, and a well-developed venture capital ecosystem.
4. A consistent rule of law, easy access to data, and developed infrastructure.
5. A large, homogeneous domestic market that allows companies to grow to scale domestically before needing to focus on the complexities of global operations.
6. Leading capabilities in many industries that are the main growth drivers of the economy today and likely tomorrow, such as technology and biotechnology.

In short, the growth prospects for U.S. companies—and therefore U.S. stocks—remain compelling with structural competitive advantages that should persist over the long term.

Defining U.S. Small, SMID, Mid, and Large-Cap Equities

Having made the case for “why U.S. equities,” now we can get back to determining how to allocate to them. To start, it’s important to understand what constitutes U.S. equity size classifications and the extent to which these categories are distinct versus overlapping. This provides one method of determining the optimal exposure mix.

A common classification is to use the constituents of the standard size-based investment benchmarks as noted below.

The $10-40 billion market cap space is particularly underinvested in across the smaller and large cap indices, despite it representing an attractive blend of established business models and high growth prospects.

A mid cap allocation provides distinct exposure to areas of the market that aren’t well addressed by the other benchmarks.

Mid Caps Are a Perfect Complement to Large Cap/S&P 500 Passive Investing

Despite the category name “mid caps” suggesting an investable universe with limited if any small cap exposure, mid caps as defined by the Russell Index is actually a very broad category: as of September 30, 2023, the minimum constituent had a market cap of $452M USD and the maximum was $53.5B USD. We use these parameters as a guideline for portfolio construction. This breadth allows for investing in most publicly traded U.S. companies below the large caps; its maximum market cap is set at the bottom end of the S&P 500 constituents, and it extends down to a size that captures most of the established, up-and-coming companies. In other words, mid caps are a perfect complement to large cap/S&P 500 investing, giving access to “the rest of America”.  

Over the long term, mid caps have meaningfully outperformed both small caps (less established businesses) and large caps (less growth).

While large cap stocks have led the charge for performance in more recent memory, the market leadership in large caps has been very narrow, with a small group of mega cap technology companies generating an overwhelming amount of the total return. When the performance of those handful of companies is removed from the S&P 500, the returns moderate considerably.

Investors betting this narrow market leadership will persist for the next decade are taking a gamble with their portfolio if they don’t have meaningful small and mid cap exposure. Instead, risk-aware U.S. equity investors should consider positioning their portfolios to be resilient across a variety of outcomes by pairing their U.S. large cap exposure, be it passive or active, with a mid cap allocation. 

Mid Caps Are the Sweet Spot of Size in Development

In our experience, the $5-40B USD market capitalization range is that sweet spot where mid cap companies have established their competitive advantages and business models but often are still at a size where there is meaningful growth left in their runway.  

Most companies in global markets, such as Canada, tend to hit their sweet spot in the $500M-4B USD market cap range as they saturate their domestic market, develop scale, and solidify competitive advantages. Most other advanced economies are about 1/10 the size of the U.S. economy, and so it makes perfect sense then that in the U.S., companies that are $5-40B USD of market cap are in the same stage of development as the global small cap companies we’ve invested in as a firm.  

Another case in point, our global small cap strategy has always had an underweight to the U.S. relative to its index; they have found more attractive companies in their cap size range in Europe and Asia rather than in the U.S. as many U.S. companies below $5B USD market cap are not yet at an established scale to have strong competitive moats.

Mid Caps vs. SMID Caps?

Small-mid (SMID) cap is generally more established as the complement to large cap investing. There isn’t one universal definition of SMID, however it generally sets an upper market cap band of $20B USD.

While it’s technically the definitionally most accurate complement to U.S. large caps (the S&P 500 traditionally are the 500 largest listed U.S. companies, and the Russell 2500, the SMID index, is the Russell 3000 – the all cap index, minus the 500 largest companies), the fact is that most large cap managers (or the passive index) have a very small weight in the bottom end of the S&P 500, and conversely, SMID managers might not always have a high concentration in companies at the top end of the Russell 2500’s market cap range because if they keep growing, the manager has to sell them.

While in theory, active large cap managers may choose to come down into the mid cap segment, and active SMID-cap managers may move up, the reality is there ends up being a gap in the weightings of most investors’ portfolios in companies in the mid cap range; and, as we said, in our experience, these tend to be the primary sweet spot of companies to invest in in the U.S equity universe. This sweet spot is underinvested in across many investor portfolios because of market conventions for defining asset allocation categories.  A mid cap strategy solves for this problem by providing the ideal coverage with U.S. large cap allocations without completely forfeiting exposure to small cap companies.

You Want to Go Active in Mid Caps 

The U.S. equity market is known for having a bias towards higher quality companies than global peers. By high quality, we mean companies which are wealth-creating by virtue of their competitive advantages. This leads them to have more stable earnings, higher margins, and stronger balance sheets. However, the degree of quality varies widely by market cap segment.

A rudimentary proxy used to assess company quality is return on equity (ROE). The higher the return on equity, all else equal, the higher average quality. The large cap universe—represented by the S&P 500—is very high quality: companies with ROEs typically in the low to mid-20s. For comparison, the Russell Midcap Index is typically more in the mid-teens and the Russell 2500 (the SMID index) in the mid to high single digits and the Russell 2000 (small cap index) has even seen periods of negative ROE. As you decrease in market cap, the ROEs decline significantly. 

Lower market cap companies are also affected by near-term market sentiment that is detached from company fundamentals more pronouncedly than larger cap companies. The meme stock craze of 2021 is an excellent example of this, with retail traders piling into the stock of companies like GameStop Corp and AMC Holdings. As shares of these companies briefly shot up without any real improvements to the underlying businesses, passive index strategies that received new inflows would have been rebalancing into these stocks (as they now made up a larger weight in the various indices) only to see those stocks slowly revert to their negative long-term trend.  

Another way to think about average quality is to look at the proportion of each universe where the companies don’t earn a profit. Despite the impressive market caps, there is a substantial group of mid cap companies that are not profitable. In some cases, the growth trajectory of the business may justify a large market cap despite the current lack of profitability, but in many cases, these are just low-quality businesses which an active mandate would avoid owning.

Whether it’s looking at ROE, momentum/hype stocks, or absolute profitability, the results are clear: when you go below large caps, you typically sacrifice quality.

Conclusion

Diversification is arguably the only free lunch in investing and mid cap stocks offer investors uniquely attractive properties: higher quality and liquidity than small caps and greater growth potential and lesser concentration of returns than large caps. Naming conventions aside, if investors are seeking an optimal exposure to small, mid, and large market cap U.S. companies, we believe the best way to do this is by pairing a dedicated mid cap allocation with a large cap allocation.