U.S. mid caps: look in the middle for diversification opportunities

Having a diversified equity strategy is important to better navigate economic cycles and market volatility; we explain why a diligent selection of mid-cap companies can be a great complement to large caps in the current inflationary environment.

The U.S. equity market is by far the largest, deepest, and most dynamic in the world, with many investors relying heavily on this asset class to meet their financial objectives. U.S. equities are also performers, having historically delivered strong, long-term returns across all market capitalizations.

However, even though the U.S. equity market is deep and historical long-term performance is comparable between large, mid, and small caps on a risk-adjusted basis, the most widely used solution to fulfil U.S. equity exposure is large and mega caps in the form of the S&P 500 Index, the world’s most liquid index. It’s also considered to be broadly diversified.

But is that really the case? While we can’t deny the liquidity argument, U.S. large caps may not provide investors with as much diversification as they used to do, as the S&P 500 Index has become more concentrated than ever in recent years.

To tap into all the innovation and growth potential the United States has to offer and to benefit from greater portfolio diversification, we believe that investors should consider broadening their scope beyond large caps, and that this natural evolution is a shift to mid-cap companies.

U.S equities have rewarded long-term investors

Investment growth of $100,000 over 20 years

Chart comparing the total returns of the S&P 600 Index (Small caps), the S&P 400 Index (Mid caps), and the S&P 500 Index (Large caps) in U.S. dollar terms from December 2001 to December 2021, and the Sharpe ratios of these three indices over the same period. The chart shows that, on an total return basis, small caps were the best performers during the period while, on a risk-adjusted basis, returns are comparable, with large caps slightly outperforming mid caps and small caps.

Source: Manulife Investment Management, Macrobond, as of December 2021. Small caps are represented by the S&P 600 Index, mid caps by the S&P 400, and large caps by the S&P 500. The rate of return shown is used only to illustrate the effects of the compound growth rate and is not intended to reflect future values of an investment fund or returns on investment in an investment fund. Past performance isn’t indicative of future results. The indices cited are widely accepted benchmarks for investment performance within their relevant regions, sectors, or asset classes, and represent non-managed investment portfolios.

U.S. large caps are top heavy

While large caps have performed well over the long run, they may have become a victim of their own success, resulting in significant sector concentration. During large market rallies, there’s a momentum effect unfolding in market-cap-weighted indices, leading to their top holdings seeing more and more demand as they outperform. This dynamic is mainly due to index investing; as index funds receive new money, they must buy more and more of the stocks with the highest market capitalization. This creates a circular effect, driving up the price of the stocks that have outperformed, resulting in even greater concentration in these larger holdings. This is particularly true for U.S. large caps, as the S&P 500 Index is the most followed index, with three of the five largest exchange-traded funds (ETFs) in the world tracking it.

This momentum effect was in action during the bull markets leading to the tech bubble burst (2001) and before the COVID-19 pandemic (2020), as the largest five companies in the S&P 500 accounted for 19% and 18% of the Index’s weight during those two events, respectively. This concentration has increased even further, standing at 24% as of December 31, 2021. There are other factors at play that are driving this distortion (for example, the current top five companies reported overall strong earnings during the pandemic), but the fact remains that for every dollar invested in funds tracking the S&P 500 Index, 24 cents go to only five companies while the remaining 76 cents are split between the other 500 companies.1

Large caps are more concentrated than ever

Top five holdings of the S&P 500 Index (%)

Chart showing the top five holdings of the S&P 500 Index from December 1991 to December 2021. The chart shows that the index is more concentrated than ever.

Source: Ned Davis Research, S&P Dow Jones Indices, as of December 2021

Moreover, the S&P 500’s current top five companies—Apple, Microsoft, Alphabet, Amazon, and Tesla2—are all technology-focused companies and are driving a quarter of large caps’ performance. Although Alphabet, Amazon, and Tesla aren’t officially classified in the information technology (IT) sector, their core business relies heavily on different technologies, be it cloud computing, software, or mobility devices. This means that not only are large-cap investors exposed to increased concentration risk but also significant industry risk.

To be clear, we’re not opining on the quality of the companies themselves, but rather question this reality from a diversification standpoint. Having a diversified equity strategy is important to better navigate economic cycles and changes; and as large caps have become more concentrated than ever, we believe investors should consider looking at mid caps to complement their U.S. equity exposure.

Improving diversification with U.S. mid caps: security selection is key

The U.S. mid-cap market offers an extremely wide range of investment opportunities. The official S&P definition for mid caps is companies with a market capitalization between USD 3.6 billion to USD 13.1 billion; meanwhile, the Russell Midcap Index includes the 800 companies ranked between positions 201 and 1,000, by market capitalization, in the U.S. equity market. In either case, mid caps are defined solely through a market capitalization lens, which we believe doesn’t do justice to the mid-cap space or to the investment strategies that focus on it.

Stock prices—and, therefore, market caps—can swing wildly these days without changes in underlying fundamentals. GameStop’s market cap increased from just over $1 billion to nearly $25 billion in under two weeks in 2021. Did its financial position, market share, or growth prospects change so much in that small window of time? We’re doubtful.

That’s why we think that market cap alone shouldn’t be the sole criterion used to define a mid-cap strategy. We believe mid caps should be analyzed through a qualitative lens as well, as they tend to share certain characteristics that can put them at the sweet spot between stability and growth prospects. We define mid caps as companies that are at a point where they’ve typically figured out the growing pains that small caps face—such as finding the right product-market fit, building out their sales and operational infrastructure, and knowing how to scale their business—but haven’t yet reached full maturity.

Mid caps combine growth prospects and stability
Venn diagram listing different characteristics mid caps share with small caps and large caps. The infographic shows that mid caps are nimble, overlooked by investors, have high growth potential, and often operate in niche industries, like small caps, but also have established infrastructures, access to capital, developed distribution capabilities, and revenue stability, like large caps.

Source: Manulife Investment Management. For illustrative purposes only.

This broader definition can provide a chance to find companies with compelling stories and growth opportunities. These types of mid-cap companies can be separated into two main categories.

Established companies in niche industries

Mid-cap companies aren’t typically household names, but that doesn’t mean they can’t be dominant in their respective industries; rather, an industry itself may be smaller or overlooked. Commercial real estate brokers are a good example of a niche industry dominated by mid-cap players that have established competitive positions.


Another example is the domain name registry industry. The infrastructure for the .com and .net top-level domains is provided by a single mid-cap company that helps connect the world every day by directing people to the correct website when they type in any site ending with “.com” or “.net.”

Leaders in fast-growing industries

A bittersweet sentiment faced by mid-cap portfolio managers is to see a holding company grow to a point where it ultimately exits their investable universe. This typically happens when a company dominates in an industry that has grown substantially over a long period.


For example, biotechnology research and development (R&D) spending has increased significantly over the past 30 years, and this trend is likely to continue as the cost of discovering and developing a newly approved drug is becoming increasingly expensive. The drug R&D process is also highly complex, and leading providers of preclinical research outsourcing work that can help pharmaceutical companies navigate this process should be well positioned to continue to take advantage of this trend.

To be clear, our goal as mid-cap portfolio managers is to build a well-diversified, standalone strategy, and not necessarily improve diversification vis-à-vis U.S. large caps specifically. However, we do know there exist many mid-cap companies that have no large-cap equivalents, that operate and dominate in niche industries, and that can be a solid complement to an S&P 500 Index exposure.

In short, for investors to improve their U.S. equity portfolio’s diversification, we believe it’s worth considering mid-cap companies that are defined by their fundamentals and growth prospects rather than solely by their market capitalization figures—and within that broader scope, security selection is key to identifying complementary businesses. 

Improving diversification: why mid caps over small caps?

Admittedly, one could make the case that the small-cap universe can provide investors with just as many diversification opportunities as mid caps. Indeed, there are plenty of small-cap companies operating in niche industries, and we also believe that a diligent selection of small caps could result in a great complement to large caps. The main difference between small caps and mid caps, however, is that mid caps, in general, have stronger competitive advantages than their small-cap counterparts—advantages that are particularly important in the current inflationary environment.

Notwithstanding its impact on interest and discount rates, inflation isn’t necessarily a bad thing for companies—i.e., if they’re able to capture inflation, it can help them grow revenue and scale their business more rapidly. For example, if an oil company makes 1% on gasoline sales, it’ll make more money if prices at the pump are $1.50 per litre versus $1.00.

However, boosting the top line during inflationary times is normally more difficult than that for businesses. Most companies (e.g., retailers and manufacturers) sell products to their customers at a given price, and their ability to raise prices—and thereby capture inflation—depends on the advantages they have over their competitors. In other words, revenue won’t increase if a company’s price increases are done at the expense of its market shares, as it will just sell fewer units of a more expensive product.

Moreover, higher inflation usually puts additional pressure on companies’ margins as production costs also increase, and companies with dominant market positions will have a greater ability to maintain these margins.

Bargaining power

Mid caps tend to be more mature than small caps and can benefit from greater scale. Because of that scale, suppliers have less bargaining power over mid-cap companies than they have over small caps. Also, mid caps are usually at a point where their operational infrastructure is in place, versus small caps that are still building it. Thus, mid caps have a greater ability to preserve their profit margins during inflationary times.  

Top-line growth

In general, mid caps have found the right product-market fit, while small caps sometimes haven’t reached that stage yet. Thanks to this, they can bring greater value to their clients and have built brand loyalty, meaning they’re less likely to lose customers due to a price increase. Also, mid caps tend to have better competitive advantages and a leading position in their respective industries, which helps them dictate price terms in the industry without compromising market share.


Competitive positions are thus particularly important in the current environment; and while each company’s situation is different, we believe that mid caps may have, in general, stronger competitive positions than small caps. As such, we believe they’re better equipped to navigate and benefit from inflation.

Of note, it’s true that large caps have even deeper competitive advantages than mid caps, in general, and the above argument favouring mid caps over small caps during inflationary times could also be made for large caps. However, it’s important to also note that, in our opinion, the gap is significantly smaller between mid and large caps than between small and mid caps—especially the mid caps we select: the dominant companies with enough bargaining power to withstand inflationary pressures.

Today’s portfolio diversifiers, tomorrow’s potential market leaders

While U.S. mid caps have many appealing characteristics, such as profitability, growth prospects, and pricing power, we’d argue that one of their greatest benefits is diversification. Unlike large caps, which have become dominated by just a few sectors and companies, mid caps run the gamut of sectors, from IT and communications to industrials and consumer staples, and everything in between. This breadth offers investors a wide array of investment opportunities that can often fly under the market’s radar.

To maximize this diversification potential, however, it may be beneficial to be selective within that broad mid-cap market—that is, diligently targeting companies with complementary businesses and with the right balance between stability and growth prospects to build a well-diversified U.S. equity strategy that invests in tomorrow’s potential market leaders.


1 As of December 2021, the S&P 500 Index had 505 constituents and its top five constituents by weight (i.e., Apple, Microsoft, Alphabet, Amazon, and Tesla) accounted for 24% of the index. As of December 2021.

The views expressed are those of the sub-advisor of Manulife Investment Management and are subject to change as market and other conditions warrant. Information about a portfolio's holdings, asset allocation, or country diversification is historical and is no indication of future portfolio composition, which will vary. Certain research and information about specific holdings in the Fund, including any opinion, is based on various sources believed to be reliable. All overviews and commentary are for information purposes only and are not intended to provide specific financial, investment, tax, legal, accounting, or other advice and should not be relied upon in that regard.

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Jeff Mo, CFA

Jeff Mo, CFA, 

Portfolio Manager, Canadian Small Cap Equity, U.S. Mid Cap Equity

Mawer Investment Management Ltd.

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