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ETF Specialist

Mid-Cap Stocks: In the Sweet Spot

Strong past performance alone doesn't justify a dedicated mid-cap fund.

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Mid-cap blend equity funds took in more investor flows relative to assets than any other of the nine categories in the Morningstar Equity Style Box during the past three years. This could be the result of performance-chasing. Historically, mid-caps have been a great bet. With higher returns than large caps but less risk than small caps, mid-caps have generated better risk-adjusted returns. But with elevated valuations, now may not be the best time to overweight mid-caps.

Since 1926, U.S. stocks have earned a return in excess of the risk-free rate of 6.3% with a standard deviation of 18.7%. The ratio of excess return to risk, known as the Sharpe ratio, was 0.33. The Sharpe ratio can be represented as the slope of a line in a graph with risk along the horizontal axis and excess return along the vertical axis. Grouping stocks into 10 deciles by market capitalization, with the smallest stocks in decile 1 and mega-cap stocks in decile 10, mid-cap stocks would make up deciles 6, 7, and 8. The graph below illustrates the near monotonic relationship between size and risk and return. While the Sharpe ratio for the mid-cap stocks in deciles 6, 7, and 8 was higher than it was for the other deciles, there is no guarantee that will hold in the future. However, the linear relationship between size, return, and risk will likely persist.

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Michael Rawson does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.