M&A Could Make Mid-Cap ETFs Great Again

For much of the current bull market in U.S. stocks, mid-cap equities and exchange traded funds have been leaders. That trend has cooled over the past several years.

For the three years ended July 30, the S&P MidCap 400 Index trailed the large-cap S&P 500 and the S&P SmallCap 600 Index. Some market observers believe mid-caps can rise again, buoyed by tax cuts and increased mergers and acquisitions activity.

What Happened

While smaller stocks are rallying this year, mid-caps are being left behind. The SPDR S&P MIDCAP 400 ETF MDY, which tracks the aforementioned S&P MidCap 400, is up 4.1 percent year-to-date, putting it 170 basis points behind the S&P 500. The S&P SmallCap 600 is beating MDY by more than 2-to-1.

MDY's 399 holdings have market values ranging from $1 billion to $4.5 billion, though the standard widely accepted definition of mid-cap is a stocks with a market capitalization of $2 billion to $10 billion.

Why It's Important

Regarding the impact of mergers and acquisitions, “That’s the market phenomenon where companies that are deemed potential takeover targets get bid up based on a higher anticipated acquisition price,” reports Bloomberg. “Many investors see mid-cap companies as a sort of sweet spot for deals, since they’ve surpassed their infancy and shown their staying power but aren’t expensive behemoths yet.”

MDY allocates nearly 10 percent of its weight to the health care sector, a group that has already seen brisk consolidation activity this year, due in large part to the tax reform legislation passed in late 2017. The technology and consumer discretionary sectors, MDY's second- and fourth-largest sector weights, respectively, could also be fertile territory for larger acquirers.

Historical data suggest mid-caps are often favored targets. Since 2009, MDY has seen 10 percent more takeovers than its large-cap counterpart, the SPDR S&P 500 ETF SPY, according to Bloomberg data.

What's Next

While investors have been revisiting small-cap ETFs and sticking with some large-cap domestic equity funds, some mid-cap ETFs are doing fairly well in terms of year-to-date inflows.

The iShares Core S&P Mid-Cap ETF IJH, which also tracks the S&P MidCap 400, and the Vanguard Mid-Cap ETF VO, have seen combined 2018 inflows of $3.32 billion.

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