This often-overlooked index fund actually offers more potential upside than the most commonly suggested option.
If you’ve been a student of the market for any meaningful length of time, you’ve likely stumbled across advice to just buy and hold an S&P 500 index fund like the SPDR S&P 500 ETF Trust (NYSEMKT: SPY). And it’s a good tip. Not only is such a plan simple enough for anyone to execute, but it also sidesteps all the inherent risks of picking individual stocks.
If you’re a true long-term investor, though, there’s a better option for the idle money in your account. Instead consider taking a stake in a mid-cap exchange-traded index fund like the SPDR Portfolio S&P 400 Mid Cap ETF (SPMD 0.32%) or Vanguard S&P Mid-Cap 400 ETF (IVOO 0.46%), both of which are meant to mirror the S&P 400 MidCap index.
You’ll likely produce stronger returns with exposure to this often-overlooked sliver of the stock market. The numbers say so.
The S&P 400 actually beats its bigger brother index
It’s a rarely discussed nuance, but diversifying a portfolio isn’t just a matter of owning picks from several different industries and sectors. Stocks of companies of different sizes can behave differently at different times as well.
The chief challenge? Finding these smaller stocks in the first place. The large caps that make up the S&P 500 account for about 80% of the U.S. stock market’s total value. Tracking down winners among the other 20% can be tedious, particularly given how little analyst coverage many of these smaller tickers attract. An easier means of adding exposure to the mid-cap segment of the market, therefore, is with funds meant to mirror the S&P 400 Mid Cap Index — companies with market capitalizations of between $2 billion and $10 billion.
This rarely considered move has been historically rewarding. Since 1991, the S&P 400 index has outgrown the S&P 500 by a factor of nearly two to one.
Surprised? Don’t read too much into the data. The S&P 400’s average annual return isn’t leaps and bounds above the S&P 500’s typical yearly gain, particularly after factoring in the dividends many large caps pay that most mid caps don’t.
Most of the mid-cap index’s superior performance can be chalked up to the compounding of the additional nickels and dimes earned by mid caps over time. Those nickels and dimes clearly add up to quarters and dollars, though.
The big question here, of course, is why? Why are mid caps better long-term bets?
Why do mid caps outperform large caps?
The explanation for this disparate performance isn’t as complicated as you might expect. It’s quite simple, actually. Most companies smaller than the average large cap (but bigger than the typical small cap) are in a sweet spot of their existence. They’re developed enough to be self-sustaining, but have yet to reach their full revenue potential. By and large they’re just entering their high-growth years.
Take web-hosting platform GoDaddy as an example. With the company’s growth driving its shares from their post-2015 IPO price near $25 to their present price of $139, the stock recently graduated from the S&P 400 to the S&P 500. In late 2022, red-hot Super Micro Computer was also added to the S&P 400 after capitalizing on the insatiable demand for artificial intelligence data centers. The stock is up 1,000% since then. Fortinet, First Solar, and Advanced Micro Devices are other former S&P 400 constituents that eventually outgrew the index to join the bigger S&P 500.
It’s also worth pointing out that while the S&P 500 is dominated by technology stocks, the S&P 400’s top sector is industrials, followed distantly by financials, then consumer discretionary stocks. These companies tend to be more reliable long-term performers even if their stories are less scintillating. Consistency counts for a lot when all is said and done.
Data source: State Street Global Advisors. Image created by author.
That’s not to suggest that every S&P 400 name is a winner, because they aren’t. Plenty of its holdings shrink their way out of the index if not outright fail. Kohl’s and WW International — formerly known as Weight Watchers — come to mind. Yet in the end, the net upside of mid-cap winners outweighs the net downside of its losers.
Just buy it and forget it already
Do you already hold a stake in the SPDR S&P 500 ETF Trust? That’s OK. Keep holding it. You still want to diversify your portfolio as much as is reasonably possible. Holding a piece of the overall large-cap market helps you do so.
But if you’ve got an extra $1,000 (or more) that you’d like to invest elsewhere, either of these two mid-cap ETFs are a great, low-maintenance choice if for no other reason than your not having to spend time hunting down individual mid-cap stock picks.
James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Advanced Micro Devices and Fortinet. The Motley Fool recommends First Solar and GoDaddy. The Motley Fool has a disclosure policy.