Mid-Cap Funds: Worthy Investment Or Risky Business?

Investing in mid-cap funds can be a great way to boost your portfolio's performance and achieve long-term growth. Mid-cap companies, with a market capitalization ranging from $2 billion to $10 billion, offer a balance between the growth potential of small-cap stocks and the stability of large-cap stocks. They are often established businesses with proven staying power and access to cheaper financing, making them attractive investment opportunities.

However, investing in mid-cap funds also comes with risks. Mid-cap companies are typically less well-known, and their products might be gaining household recognition. This requires extra research and analysis, and the volatility associated with mid-cap stocks can be higher than that of large-cap stocks.

Ultimately, the decision to invest in mid-cap funds depends on your risk tolerance, investment goals, and time horizon. While mid-cap funds can provide diversification and strong returns, they are best suited for investors with a medium to high-risk appetite and a long-term investment perspective.

Mid-caps: A happy medium?

Mid-cap stocks are an intriguing prospect for investors, given their high-return potential and riskiness. Mid-caps are defined as companies with a market capitalization of $2 billion to $10 billion. This market cap range offers a balance of growth and stability, making mid-cap stocks a good option for portfolio diversification.

Performance

Historically, mid-cap stocks have outperformed small- and large-cap stocks over longer periods. Between 2003 and 2023, mid-caps outperformed 60% of the time with less associated risk. In addition, mid-cap stocks have generated higher absolute returns over longer time frames.

Risk

Mid-cap companies have already navigated the high-risk phases associated with startups and early market development. This means that for investors, mid-caps can represent a lower level of investment risk. However, it is important to note that mid-cap stocks are still riskier than large-cap stocks, and there is more associated volatility.

Investment strategy

When considering investing in mid-cap stocks, it is important to assess your risk tolerance and investment goals. Mid-cap stocks are generally suited to investors with a medium to high-risk appetite and a long-term investment horizon. It is also important to note that investing in individual mid-cap stocks directly can be risky, and it is recommended to invest via mutual funds or exchange-traded funds (ETFs) to benefit from the expertise of experienced fund managers.

Mid-cap stocks offer a happy medium between the risk and return potential of small- and large-cap stocks. They provide investors with opportunities for growth in well-known companies that have already demonstrated a level of staying power. However, it is important to carefully consider the risks and volatility associated with mid-cap stocks and ensure that they align with your investment goals and risk tolerance.

Historical performance

Mid-cap stocks have historically been underfollowed by retail and institutional investors, who tend to favour large-cap stocks. However, data shows that between 2003 and 2023, mid-caps outperformed small- and large-cap stocks 60% of the time over any 10-year rolling period in the past 20 years, with less associated risk.

In any given 1-year rolling period since 2003, small-, mid-, and large-cap stocks have outperformed 33%, 26%, and 41% of the time, respectively. However, the longer investors hold mid-cap stocks, the more likely they are to outperform.

In 2024, JP Morgan predicted that US small and mid-cap returns would remain strong over a 10- to 15-year investment horizon, rivalling US large caps.

Mid-cap stocks have also generated higher absolute returns over longer time frames, and have provided these returns with less associated risk than small-cap stocks.

While mid-cap stocks have historically delivered strong performance, investing in this sector is not without risk. Mid-cap companies are less well-known than their larger-cap counterparts, and their products may only be starting to gain recognition. This means that investors need to spend extra time on research and analysis.

Mid-cap stocks are also more volatile than large-cap stocks, and there is no guarantee that they will always outperform their larger counterparts.

Risk and reward

Mid-cap stocks are an intriguing investment option due to their high-return potential coupled with significant risk. The mid-cap market, comprising stocks with a market capitalisation ranging from $2 billion to $10 billion, offers investors the opportunity to balance growth and stability. While mid-cap companies have navigated the high-risk phases associated with startups, they are less established than large-cap companies, presenting a more significant level of risk.

Risk

Mid-cap stocks carry significant risks, including macro risks, company risks, and competitive risks. The underlying businesses of mid-cap stocks can experience sharp ups and downs with changing economic scenarios, leading to increased volatility. Additionally, mid-cap companies are less known than their larger-cap counterparts, requiring investors to spend extra time on research and analysis. The products of mid-cap companies might be gaining household recognition, necessitating more in-depth analysis for investors.

Reward

Mid-cap companies provide investors with growth opportunities and the potential for significant returns. They have already navigated the high-risk phases associated with startups and early market development, offering a lower level of investment risk. Mid-cap companies can access cheaper forms of financing, enabling future growth through new lines of business, expanded operations, and mergers or acquisitions.

Historically, mid-cap stocks have outperformed small- and large-cap stocks over more extended periods. Between 2003 and 2023, mid-caps outperformed 60% of the time with less associated risk. Additionally, mid-cap stocks have generated higher absolute returns over longer time frames, providing these returns with reduced risk compared to small-cap stocks.

Active vs passive fund management

Mid-cap companies are those with a market capitalization of $2 billion to $10 billion. They can be an attractive investment option as they have already navigated the high-risk phases associated with startups and offer growth opportunities with a reasonable level of risk.

When it comes to investing in mid-cap funds, or any other type of fund, you have the option of choosing between active and passive fund management. Here's a detailed comparison between the two:

Active Fund Management

Active fund management involves employing investment professionals, such as fund managers, to build and manage a portfolio of investments on your behalf. These managers actively select and monitor investments, aiming to outperform the market. Active management offers several advantages:

• Flexibility: Active managers are not restricted to holding specific stocks or bonds, allowing them greater flexibility in their investment choices.
• Hedging: Active managers can employ strategies such as short sales and put options to hedge against potential losses.
• Risk Management: Active managers can quickly adapt to changing market conditions by exiting specific holdings or sectors when risks become too high.
• Tax Management: Active management allows for tax-efficient strategies, such as selling money-losing investments to offset taxes on winning investments.
• Expertise: In certain niche markets, such as small-company stocks, active managers may have an edge in expertise and can spot hidden gems.

However, active management also comes with higher fees to compensate for the extensive research and analysis conducted by fund managers. These fees can eat into investment returns, and there is no guarantee that active managers will consistently beat the market.

Passive Fund Management

Passive fund management, also known as index-style investing, involves buying and holding a portfolio of stocks or bonds designed to replicate a specific market index, such as the S&P 500. Passive management has gained popularity due to its low fees, good transparency, and tax efficiency:

• Low Fees: Passive funds have very low fees since there is no need to actively analyze and select securities.
• Transparency: Investors always know what stocks or bonds are included in the index their investment is tracking.
• Tax Efficiency: The buy-and-hold approach of passive funds minimizes annual capital gains tax liabilities.
• Long-Term Performance: While active management may shine in the short term, passive funds have consistently outperformed active funds over longer periods, especially in large-cap markets.

However, passive management may not be as flexible as active management, and investors have less control over the specific holdings in their portfolios.

Both active and passive fund management strategies have their advantages and disadvantages. Active management can be useful for certain portions of a portfolio, especially those invested in illiquid or less-known securities. On the other hand, passive management offers a cost-effective way to replicate market returns and often performs better over the long term. A well-diversified portfolio may benefit from a combination of both strategies, leveraging the strengths of each to maximize returns and minimize risks.

When to buy and sell

When to Buy:

• Risk Appetite: Mid-cap funds are generally considered riskier than large-cap funds but offer higher return potential. If you have a medium to high-risk appetite and are comfortable with the volatility associated with mid-cap funds, they can be a good addition to your portfolio.
• Time Horizon: Mid-cap funds are typically suitable for long-term investments. If you have a long-term investment horizon (at least five years or more), you may have a better chance of riding out the volatility and capturing the potential growth of mid-cap companies.
• Diversification: Mid-cap funds can provide diversification benefits to your portfolio by offering exposure to a different set of companies than large-cap funds. If you are looking to add variety to your investments, mid-cap funds could be a good option.
• Fundamentals: Consider the fundamentals of the mid-cap companies in the fund, including their financial health, management team, and growth prospects. Look for companies with strong business models, experienced management, and a track record of performance.
• Valuations: Evaluate the valuations of the mid-cap companies in the fund. Look for companies that appear undervalued or are trading below their intrinsic value. This can indicate a good entry point for investment.
• Market Conditions: Keep an eye on overall market conditions and try to identify periods when mid-cap funds may be undervalued or overlooked by other investors. Buying during market dips or when investor sentiment is bearish can potentially offer better entry points.

When to Sell:

• Fundamentals Deteriorate: If the fundamental characteristics of the companies in the mid-cap fund deviate from your investment thesis or their business outlook deteriorates, it may be a sign to sell.
• Overvaluation: If the stock price of a mid-cap company in the fund exceeds the underlying value or becomes overvalued relative to its peers, it may be a good time to sell and lock in profits.
• Risk Management: If you need to control risk in your portfolio, you may consider selling or reducing your position in the mid-cap fund, especially if it becomes too large of a portion of your overall holdings.
• Underperformance: Monitor the performance of the mid-cap fund relative to its benchmark or category. If the fund consistently underperforms for an extended period (typically two years or more), it may be a sign to exit the investment.
• Investment Goals: If you are nearing your investment goals or your investment objectives change, it may be appropriate to sell your mid-cap fund and reallocate your portfolio accordingly.
• Better Opportunities: If you identify more attractive investment opportunities elsewhere that better align with your goals and risk appetite, you may consider selling your mid-cap fund and deploying your capital towards those opportunities.

Remember, the decision to buy or sell mid-cap funds should be based on a comprehensive evaluation of various factors, including your personal financial situation, investment goals, and risk tolerance. It is always advisable to consult with a financial advisor or expert before making any investment decisions.

Frequently asked questions