Traditionally, a stock fund investor who wanted to diversify a primarily large-cap portfolio would turn to small caps. In recent years, however, investors have begun to discover that mid-cap stock funds can also diversify a large-cap portfolio, and typically with less risk (volatility) than small caps.

What Are Mid Caps
The Frank Russell Company, creator of the Russell indexes, the standards used by most investment firms, breaks the overall market down as follows:

	Range of Market Capitalization	Number of stocks
Large Caps:
Russell Top 200 Index	Over $12 billion	200
Mid Caps:
Russell Midcap Index	Between $1.6 billion- $12 billion	800
Small Caps:
Russell 2000	From $175 million - $1.6 billion	2,000

Mid-caps make up roughly 20% of the U.S. stock market’s capitalization (large caps make up roughly 70%, while small caps come in at about 10%).

While this once relatively ignored asset class has become more recognized by investors in recent years, they still fall under some radar screens, receiving somewhat less attention on Wall Street. And that means good opportunities for smart investors.

Proven Growth
In fact, today, mid-sized companies are often described as the “sweet spot” of the domestic stock market. By virtue of rising from small- to mid-sized status, mid-cap companies have demonstrated that they can grow, and their operations and management can effectively handle such growth. So some of the risk associated with small caps has been removed. These companies are essentially in the prime of their growth cycle, and are positioned for exceptionally high return potential. And because of their size, they are now better able to handle difficult times, and are less likely to go into bankruptcy than a smaller company. While large-cap stocks are typically even less volatile than mid-caps, their growth potential is generally less, too.

The Most Successful Small Caps
In particular, companies that have matured from the small- to mid-cap range have proven that they can sustain growth in their business beyond their initial “idea.” They may have shown that they can broaden their revenue stream, by adding new innovative products to their original lineup. Or they have developed new distribution channels to service areas they couldn’t before, by outsourcing and establishing strategic alliances. The strength of management often grows along with the company, as executives build in-depth experiences with the strains and demands of building and managing a growing business. In short, many mid-caps can be looked upon as the most successful small-caps. These tend to be mid-cap growth stocks.

The Least Successful Large Caps
Of course, there is another way a company can fall into the mid-cap universe. Large-cap stocks that do not stay competitive with their peers may eventually slip back into the mid-cap range. While this can mean that the best is over for these firms, that is certainly not always the case. They have already shown they can grow, and they tend to have a solid infrastructure in place. They may have slipped for a bit due to various circumstances, but it is not uncommon for companies in this type of situation to right themselves and climb back into the large-cap arena. Sometimes all it takes is a new innovative product to revitalize the business. These tend to be mid-cap value stocks.

Mid-Cap Performance
Given the characteristics of small-, mid- and large-cap companies, it is reasonable to expect that mid-cap companies would have a return potential somewhat lower than small caps, but higher than large caps. Similarly, you would expect their returns to be less volatile compared to small caps, but more volatile than large caps.

Unfortunately, due to the relatively recent upsurge in interest in the mid-cap universe, reliable index data for mid-caps does not go back very far. Over the last 1, 3 and 5 years, however, mid-caps have fared even better than one might expect. While their volatilities have indeed fallen between small- and large-caps, their returns have been better than both -- as shown below:

While it is unlikely that mid-caps will continue to outperform both large- and small cap- stocks, a look at the relative volatilities of the three types of stocks over the same time periods is revealing:

We see above that while, as noted above, the volatility of mid-cap stocks has fallen between small and large caps, it has been much closer to large caps than to small caps (i.e. lower), particularly over the last three and five years.

This offers a tantalizing prospect. If mid-caps, by virtue of their “survival” beyond small-cap status, have volatilities similar to large caps, but still possess growth prospects that are more similar to small caps, then they truly may represent the “sweet spot” of the stock market. While not always offering the best absolute return potential, they may well offer the best combination of risk (volatility) and return, or risk-adjusted return.

The Bottom Line
Regardless of whether or not mid-caps ultimately prove to be the market’s real sweet spot, a well-diversified portfolio today should have some exposure to this overlooked area of the market, rather than just focusing on large caps and small caps. In fact, under normal circumstances, given that they make up twice the percentage of the overall market as small caps, mid caps should arguably have a larger representation in your portfolio.