The distinct performance profile of the U.S. equity market’s mid-cap constituents has presented investors with an opportunity over much of the past two decades. Not unlike the human life cycle, companies go through periods of growth and maturation. Mid caps capture a period in the typical enterprise life cycle in which firms have successfully navigated the challenges inherent to small companies, such as raising initial capital and managing early growth, but are still quite dynamic and not so large that rapid growth is unattainable. The performance of the S&P MidCap 400® reflects this business dynamic. The index has outperformed the S&P 500® and the S&P SmallCap 600® for most of the past 20 years.
For the most part, mid caps have consistently outperformed large caps over various timeframes. With the exception of the period from July 1991 to March 2000, when the performance spread was negligible, the S&P MidCap 400 has outperformed the S&P 500 in periods with contrasting market regimes (i.e., in both weak and strong markets).
THE EFFICIENT MARKETS HYPOTHESIS—NULL FOR THE MID-CAP SEGMENT?
Advocates of active management argue that there is a stronger case for passive investing in the large-cap segment and more room for the role of the active manager in the mid- and small-cap arenas. This view is based on the assumption that the efficient markets hypothesis (EMH), which posits that share prices account for all relevant information, and therefore always trade at fair values, is more applicable to large caps because there is better research coverage of the big names in the market. Mid- and small-cap companies, in contrast, are often thought to be under researched and would therefore offer more fertile ground for active managers.
Neither theory nor evidence supports the idea that the EMH is any less applicable to mid- and small-cap companies. The argument for passive investing in any market segment is illustrated by William F. Sharpe using simple arithmetic1: the market return is the weighted average of the returns on the passive and active segments of the market. If returns on the passively managed segment of the market equal the market return, then the return on the actively managed segment must also mirror the market. Therefore, the average passive manager will generate the same returns as the average active manager, before expenses.