Mutual Funds: Taking The Middle Way

Midcaps are outpacing bigger rivals yet are less risky than small-cap companies

Mutual fund investors started 2007 as they had the last few years—debating whether to move money into large-cap stocks or keep their bets on small caps, which have beaten the blue chips seven years running. While everyone was focused on the big and the small, stocks in the middle have actually turned in the best performance so far this year. Funds specializing in midcap stocks, those companies typically with a market capitalization of $2 billion to $20 billion, have risen 11% since January, beating the 8.4% gain in small-cap funds and 7.6% return on large-cap funds, according to Morningstar (MORN ). Among midcaps, growth-oriented funds have done best, advancing 11.5%, vs. 10.2% for midcap funds that focus on value stocks.

What's behind the surge? Midsize companies are the place to be when economic growth and corporate profits are slowing. Because of their size, they're able to grow faster than larger competitors, yet they're financially sturdier than the small-cap companies. Some of it has been luck, too. As a percentage of the index, the Standard & Poor's MidCap 400 has about twice the weighting in basic materials and utilities stocks as the S&P 500-stock index, and both sectors have been hot this year. Investors have taken notice. They pumped $8 billion into midcap funds in the first quarter, up from $3 billion for all of 2006, according to market tracker Financial Research.

The midcaps' prospects seem bright. While analysts forecast that operating profits at companies in the S&P 500 will increase 20% over the next two years, those for members of the S&P MidCap 400 will jump 32%. Small-cap earnings are projected to rise 29%, but profits at those companies could be jeopardized if the economy slows sharply. "With small caps, you're either going 80 miles an hour or you're crashing," says Arieh Coll, manager of the Eaton Vance Tax-Managed Multi-cap Opportunity Fund (EACPX ). "The odds of an accident with midcaps are greatly reduced."

Investors should aim to have about 25% to 30% of their U.S. equity allocation in midcaps, according to Brett Hammond, chief investment strategist at TIAA-CREF. That's about what you would find in the broadest market indexes, such as the Russell 3000 or Wilshire 5000, so funds based on those indexes are one way to take a stake in the midcap sector. There is no shortage of mutual funds specializing in midcaps, either. (View them on the BusinessWeek Mutual Fund Scoreboard at bwnt.businessweek.com/mutual_fund/.)

THE GRADUATES

The middle of the market has benefited indirectly from the seven-year small-cap rally. Many of the best small companies have seen their market value appreciate so much that they've graduated to midcap status. "The cream has risen to the top," says Daniel Thelen, a small-cap and midcap stock manager at Loomis Sayles in Boston. At the end of May, for example, S&P promoted three top-performing companies to its MidCap 400 index. Five years ago, Digital River (DRIV ), Endo Pharmaceuticals (ENDP ), and Equity One (EQY ) had market caps of under $1 billion. But after gaining 630%, 224%, and 86%, respectively, they've climbed to an average market cap of $2.8 billion.

The mergers-and-acquisitions boom has also contributed. Private equity funds raised almost $250 billion last year, and midcaps make a good hunting ground for them. Most small-cap companies don't interest the big funds as acquisition targets while megacaps remain out of reach for the most part. Companies such as Duquesne Light (DQE ) and Claire's Stores had to be removed from midcap indexes in May because of takeovers.

There are few signs to suggest the midcaps are overheating. Earnings have risen faster than stock prices, so the price-to-earnings ratio of Russell's midcap index, 26 at the end of May, was actually two points lower than where it stood three years ago. Jeff Parker, chief investment officer for growth funds at Allianz Global Investors, says the midcaps' strong momentum should keep them in the lead for a while. "With midcaps," says Parker, "you get the best of all possible worlds."

By Aaron Pressman

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