The simple explanation for this might be that mid-caps are in the sweet spot of the risk-reward trade-off. They are typically growing faster than large-caps, and yet have less risk and volatility than small-caps.

Mid-caps are in the sweet spot of the risk-reward trade-off.

But one investor’s sweet spot is another investor’s no-man’s land. As a group, mid-cap stocks, despite better returns, do not receive their fair share of attention. In fixed-income investing, many individuals embrace the notion of barbell investing—choosing two more-extreme options over the single point in the middle, also known as a "bullet." Although one might apply this same logic to other opportunities, it does not translate well into market caps for equity investments. With the popularity of Morningstar-style boxes, some investors and advisors tend to take a similar approach, looking to the corners and ignoring the middle sections. They think that these are not pure plays and that they have exposure to the higher growth potential of small-caps and the stability of large-caps. But investors beware: A portfolio of some small-cap and some large-cap investments will not necessarily average out and perform similarly to that of a mid-cap portfolio.

Manager’s Pick
Ironically, it’s the favorable combination of attributes mid-caps share with other market segments that differentiates them. These are the companies that have emerged from the populous small-cap universe, some of which will continue along the curve to become large- and mega-caps. With plenty of growth opportunity ahead and more-focused business models, mid-cap stocks also tend to have higher-quality management teams, solid balance sheets and better access to capital.

On the surface, this doesn’t quite add up. If mid-caps are under-owned in terms of the number and assets of funds dedicated to the space, and they do not get their fair share of attention from retail investors or the financial press, then who actually owns the stocks? It turns out mid-cap stocks are regularly the secret weapons of both large- and small-cap managers. Small-cap portfolio managers often have exposure in the mid-cap territory because they have owned stocks that have grown into mid-caps. They also seek out mid-caps to provide extra stability. For large-cap managers, the universe of true large-cap stocks is small, causing managers to have a difficult time differentiating their portfolios from those of the competition; they all own a lot of the same stocks. Owning an up-and-coming mid-cap stock can give large-cap managers an edge, while usually boosting the portfolio’s earnings and revenue growth rate at the same time.

While mid-caps offer less company-specific risk than small-caps, there is risk to the asset class itself. The flow of funds from large- and small-cap managers could potentially reverse. In rapidly changing market climates, investors tend to shift bets at one end of the spectrum or the other, and the middle ground gets left out. Additionally, the outstanding performance that mid-caps have enjoyed could lead to a period of mean reversion, where returns moderate. As some companies grow from small-cap status into mid-cap territory, they become big enough that maintaining revenue and earnings growth rates proves difficult. As growth rates moderate simply because of company size, some mid-cap stocks can experience valuation compression. Investors should be mindful of such situations, but also consider using these periods to opportunistically build a position in a great company.

Chasing the best-performing asset class is not sound advice. But investing in mid-caps is not about chasing returns. It’s about considering exposure to a segment that represents a favorable blend of risk and reward. Maybe one day this segment will be in the limelight, and that extra attention might serve to enhance returns even further. But, for now, investors can follow the professional money managers who already enjoy this sweet spot.

Ryan Crane is chief investment officer at Stephens Investment Management Group in Houston.