This article mentions funds that have an issuer-initiated rating and/or track a Morningstar Index. For full disclosure information, please refer to the specific funds, which are demarcated with a * symbol, listed below.
The mid-cap market can be difficult to navigate since there is no universally accepted definition for what a mid-cap stock is. But it can be a rewarding segment since mid-caps offer a balance of higher growth potential than large caps and more stability than small caps.
Large-cap index funds have a relatively easy job in sorting their universe: start at the top and pull in roughly 80% of the market. Mid-caps have more gray area.
Most portfolios of mid-cap index funds are market-cap-weighted, which is a simple, cost-effective approach that sizes positions based on company size. Turnover and trading costs stay low because position sizes adjust automatically as prices change. This, combined with their typically low fees, has historically given mid-cap index funds a durable edge over most actively managed peers.
Divergent definitions of mid-cap stocks lead to divergent portfolios and performance. But there are a few rules of thumb that can help investors decide which mid-cap index fund is right for them.
Staying Within a Universe
Investors looking to round out their stock sleeve with a mid-cap exchange-traded fund should stay within an index family and universe. S&P, Morningstar, Russell, and others all offer indexes tracked by ETFs. Choosing ETFs that follow indexes from the same provider reduces the chance of unnecessary portfolio overlap.
S&P offers mid-cap indexes in several universes, notably the S&P 1500 (composed of the S&P 500, MidCap 400, and SmallCap 600) and Dow Jones US Total Stock Market indexes. The S&P 1500 uses the same profitability screen and committee-based approach as the S&P 500. Pairing the State Street SPDR S&P MIDCAP 400 ETF MDY with the State Street SPDR Portfolio S&P 500 ETF SPYM would be a great option, for example, since the two portfolios don’t overlap. Both ETFs earn Gold Morningstar Medalist Ratings too.
Some indexes overlap by design. The Dow Jones US Total Stock Market Large-Cap and Mid-Cap components had roughly 300 shared holdings at the end of July. However, differences in holding sizes make the two portfolios look very different and allow them to complement each other in an investor’s portfolio. If the goal is to dial up mid-cap exposure relative to the broader market, the mid-cap index is a solid choice. Schwab offers gold-rated ETFs that track both indexes: Schwab US Mid-Cap ETF SCHM and Schwab US Large-Cap ETF SCHX.
Each index universe defines mid-cap stocks differently. Different definitions lead to ETFs that vary significantly in the average size of their holdings. That’s important because the top holdings, which tend to have the most sway on performance, will likely differ among ETFs. Consequently, performance across mid-cap index ETFs diverges more compared with large-cap index ETFs.
Fees, Fees, Fees
Cheap funds tend to be the best performers, regardless of portfolio differences. This connection has been proven time and again, and investors are usually best served buying inexpensive ETFs.
Why Choose an ETF Over a Mutual Fund?
Most investors access mid-cap index strategies through ETFs and mutual funds. ETFs trade on an exchange throughout the day like a stock, while mutual funds price once daily after the market closes.
There’s virtually no difference between the two vehicles for investors in tax-deferred accounts like health savings accounts, IRAs, or 401(k)s, assuming all dividends are reinvested.
The vehicle matters more for investors in taxable accounts. The in-kind creation and redemption mechanism enables ETFs to mostly avoid capital gains distributions, making them more tax-efficient than mutual funds. In fact, none of the largest mid-cap index ETFs has distributed capital gains in the past decade. Most mid-cap index ETFs and mutual funds also engage in securities lending, allowing them to earn back a portion of their fees and slightly improve investor returns.
Capital gains distributions from mutual funds tend to be small, but they’re not zero. Investors in taxable accounts will need to pay Uncle Sam a portion of those distributions, even if they didn’t sell a single share. That’s a small but noticeable cost to mutual fund investors.
The Best Mid-Cap Index ETFs for Long-Term Investors
Choosing a low-cost fund is always a smart option for long-term investors, and those with taxable accounts should likely favor ETFs. If an investor wants to pair a mid-cap fund with a large-cap or small-cap index fund, matching the index family and universe to avoid overlap is wise.
Below are some of our favorite mid-cap index ETFs, including iShares Russell Mid-Cap ETF IWR and Vanguard Morningstar Mid Cap ETF
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A Simpler Option
Investors looking for total market exposure can purchase a total market fund. It’s a simpler option than stitching together large-, mid-, and small-cap index funds of the same family and universe. It also relieves the investor from deciding on how to size each ETF holding. Cheap total market ETFs are a great place for investors to get started.
