What Investors Should Understand About Mid-Cap Exposure Through VO (or MDY)

Key Points

As a group, mid-cap stocks boast a stronger long-term track record of returns than their large-cap counterparts. This ETF is not only better balanced in terms of sector allocation but also offers a distinctly different sector weighting that might complement most large-cap index fund holdings. In the same sense that the market’s biggest and best-known ETFs should mostly be considered long-term positions, that’s even more the case for mid-cap funds.10 stocks we like better than Vanguard Mid-Cap ETF ›

Is your gut telling you there's just something not quite right about the market at this time? If so, you're not imagining things: Too many stocks are overvalued as well as technically overbought. It also feels like a few too many companies are vulnerable to some sort of economic turbulence ahead, even if we don't know what turbulence might be brewing.

Be wary of coming to sweeping generalizations about "the market," though. It's not every stock. Indeed, you may already realize that most mid-caps don't bring any of these worries to the table right now. The S&P 400 Mid Cap Index's forward-looking price/earnings ratio is unusually low at 17.7, in fact, while the S&P 500 Large Cap Index's is unusually high at around 23.

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That's why you might even be mulling a stake in the Vanguard Mid-Cap ETF(NYSEMKT: VO) here or the comparable SPDR S&P Midcap 400 ETF Trust(NYSEMKT: MDY). If you are, good choice. And if not, you should give the idea some thought.

Either way, here are five key things you'll want to know about what exposure to VO or MDY can do for your portfolio.

1. In the long run, mid-caps will probably outperform large caps

This hasn't been the case of late, after a small number of large-cap companies essentially created the artificial intelligence (AI) industry and then capitalized on it like there's no tomorrow. Most of the time, though, as a whole, mid-caps outperform large caps.

Data by YCharts.

This makes sense, of course. Most mid-caps are in their high-growth phase, after the launch of a new business or product is getting traction, but before sheer size makes it tough to further penetrate the market or produce massive year-over-year growth.

2. It's also more volatile than large-cap ETFs

These superior gains come at a price, of course. Chief among these costs is the fact that mid-cap stocks as a whole tend to be more volatile than large caps are. This is particularly true when it comes to prolonged pullbacks or major corrections -- mid-cap investors tend to panic, and without as much institutional interest as there is in large caps, it doesn't take much selling to quickly do some serious damage to these tickers.

Of course, mid-cap stocks and their corresponding ETFs also tend to bounce back much more aggressively.

3. You'll get much different sector diversification

If you think you're getting great sector-based diversification by owning the SPDR S&P 500 ETF Trust(NYSEMKT: SPY) or the Vanguard S&P 500 ETF(NYSEMKT: VOO), guess again. Since these funds are based on a cap-weighted index and most of the market's biggest companies right now are technology companies, more than 30% of both SPY's and VOO's values are made up of tech stocks. At the other end of the spectrum, utilities account for less than 3% of both of these large-cap funds' values, while all-important industrials only make up about 9%.

The Vanguard Mid-Cap ETF and SPDR S&P Midcap 400 ETF Trust aren't perfectly balanced sector-wise either, for the record, although both are better balanced. Perhaps more important, though, their sector allocations are quite different than SPY's or VOO's. VO and MDY are most exposed to industrials, which make up more than one-fourth of their total value, while tech stocks make up less than 14% of these funds' values. They also hold measurably more basic materials and real estate exposure than their large-cap counterparts.

If nothing else, owning mid-cap and large-cap index funds at the same time should reduce your overall net volatility just a bit simply by spreading out your sector exposure.

4. It's a better bet than picking individual mid-cap stocks

So you'll just start picking more individual mid-cap stocks? It's easier said than done. In fact, most professionals can't even do it well enough to actually beat the S&P 400.

Numbers from Standard & Poor's put things in perspective, indicating that over the course of the past five years, more than 73% of mid-cap mutual funds underperform their benchmark index. And things get worse the further out you look. For the past 10 years, nearly 77% of these funds failed to keep up with the S&P 400, while nearly 84% of these funds underperformed the benchmark over the course of the past 15 years. (And if you're wondering, no ... it's incredibly rare for the few leading funds in one time frame to remain a leader in another.)

It's a testament to just how difficult it is to identify the hidden gems within the mid-cap segment of stocks!

5. It's more of a philosophy than a strategy

Finally, while picking individual stocks -- or even choosing to invest in the broad market by owning large-cap index funds -- is inherently strategic, mid-cap index funds might be best viewed through a different lens. That is, owning them is more of a philosophical idea, recognizing the fact that many companies among the market's mid-caps are en route to becoming large-cap names, but you don't know which ones! That's why you'll want to buy them all as a bunch and then simply hold on to that basket for the long haul while the fund's managers swap out its holdings as necessary.

In other words, if you're only thinking about owning Vanguard's mid-cap ETF or SPDR's mid-cap ETF as a temporary place to park some money while waiting for clarity from other segments of the market, you're somewhat missing the point.

Perhaps the overarching takeaway here, however, is that right now, most long-term investors would be wise to own at least a little more long-term exposure to mid-cap stocks via exchange-traded funds.

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James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard Mid-Cap ETF and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.