Franklin Templeton : Many investors are happy to be moving on from the market volatility of 2022, which left a mere few good places to hide.
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by Dina Ting, CFA, Head of Global Index Portfolio Management, Franklin Templeton – ETFs
Quite notably, however, exchange-traded funds (ETFs) drew impressive investor interest last year. Overall ETF usage marked a new annual record of over US$45 trillion in trading volume by the end of 2022—about US$10 trillion more than 2021’s haul.1 US ETF net inflows also reached nearly US$600 billion in 2022, with nearly US$38 billion in December.2
Following an extended winning streak for the large-cap US growth sector, big technology sector weakness led to much of the red seen in 2022, which may signal that a rotation is underway. In our analysis, while US small-cap stocks remain cheap, they may experience greater volatility and encounter lower liquidity amid interest rate hikes, especially should markets enter recessionary territory. Looking ahead, investors seeking consistent exposure to equities that may be able to better withstand turbulence than other asset classes may find it an ideal time to consider overlooked mid-cap stocks.
Why mid-caps?
Hitting the so-called “sweet spot,” US mid caps—generally defined as companies with market capitalization between US$2 and US$10 billion—can offer faster growth prospects than large caps along with a lower risk profile than small caps.
Mid caps also have a history of outperformance in periods following financial recessions. From 2003 until 2006, mid caps outperformed large-cap stocks for three consecutive years following the recession of the early 2000s. Looking at annual total return from 2009, mid caps similarly outperformed over four out of the five years after the global financial crisis. Not only did they also perform well compared to the small-cap segment post-recession, but the cumulative returns from the start of 2000 through December 2022 show the Russell Midcap Index far outpaced the large-cap Russell 1000 Index with returns of 598% versus 334%.3
Another added benefit of this sometimes-forgotten segment is diversification. Mid-caps tend to be less impacted by currency fluctuations and global downturns than large caps, which often include major corporations and multinationals that operate around the world.
Investors also tend to be underallocated to mid caps. Based on overall market capitalization, we might expect funds to allocate three times as much to large caps compared to mid-caps. However, investment in large-cap mutual funds and ETFs is about seven times more than that of their mid-cap peers.4 Market observers have lamented that US large caps have become even more concentrated, as they are dominated now by mega tech holdings.
At the end of 2022, technology sector holdings comprised 24% of the Russell 1000 Index, including 13.4% of the top 10 holdings in the index.5 Meanwhile, tech sector holdings in the Russell Midcap Index made up just half that at 12%, with tech representing just 1.5% of its top 10.6
Beyond the market-cap criteria, we believe that multifactor strategies can potentially deliver enhanced diversification with higher risk-adjusted returns and lower volatility than traditional market cap-based indexing. In our view, a forward-looking, rules-based index design that analyzes individual stock exposure against a well-vetted blend of factors—quality, value, momentum and low volatility—helps provide exposure to high-quality companies at a reasonable price while avoiding value traps.
As shown in the table above, the value factor—which emphasizes inexpensive stocks relative to their fundamentals—performed better than the broader market last year, with the S&P MidCap 400 Pure Value Index returning -3.6% against the S&P MidCap 400 Index, which was down about -13% for the year.7 By comparison, momentum stocks, which tend to show ongoing positive price trends, underperformed the most in 2022. Quality-tilted stocks, marked by profitable companies with capital efficiency and low volatility traits, together helped hedge against risks.
We believe a strategic combination of these factors can result in a smoother return profile, which should appeal to investors as we embark on another year of shifting market conditions.
Source: ETFWorld
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