Midcaps Double S&P 500 Return: Get the Right ETF

Granted, Regeneron Pharmaceutical (REGN) Kansas City Southern (KSU) and Vertex Pharmaceuticals (VRTX), the three largest stocks in the S&P 400 Midcap index don’t exactly have the same name recognition as Apple (AAPL), Exxon Mobil (XOM) and General Electric (GE), the mighty triumvirate of market caps in the S&P 500. But the no-names are part of the better performing index for the past one, three, and five years. And as shown in this chart, the middies have doubled the return of the large caps over the past 10 years, as seen in a stock chart.

^MID Chart

^MID data by YCharts

In a recent white paper, Goldman Sachs Asset Management made the case that retail investors are underweight midcaps. It noted that while stocks in the middle range (market caps typically between $2 billion and $10 billion) represent about 24% of the broad market, retail investors have an estimated 15% of their stock portfolios invested in midcaps.

The thing is, midcaps are a bit pricey. Given their growth prospects are stronger than more established blue chips, it makes perfect sense that midcaps will trade at a higher price/earnings multiple than large caps. But S&P Capital says the midcap index is trading at 17.7x estimated 2013 earnings; that’s higher than the long-term average of 16.3. By comparison, S&P Capital IQ estimates the 500 index is trading at a 14.7x estimated 2013 earnings, which is below the long-term average of 15.5.

The two largest ETFs trafficking in midcap stocks, $15.5 billion iShares Core S&P 400 Midcap (IJH) and $11.7 billion SPDR S&P Midcap (MDY) are even more expensive, with forward PE’s above 18.

The high valuation seems to be a function of the financial service sector. The forward PE for the financial services sector within the S&P 400 is 20.7; the same sector in the large cap S&P 500 trades at a 12.6 forward PE. Peel down a layer though and the real culprit is the real estate subsector within financial services. It represents 11% of the iShares midcap ETF and 10% of the SPDR midcap ETF. Real estate is 2.1% of the S&P 500.

The S&P 400 index is in fact full of real estate investment trusts, a segment of the market Morningstar estimates is trading at 10% above its fair market value -- the overall market is close to fair value right now -- pushed higher by yield-crazed investors. Among the midcap REITs are Macerich (MAC), Realty Income (O), Federal Realty (FRT), Weingarten Realty (WRI) and BRE Properties (BRE).

MAC Forward PE Ratio Chart

MAC Forward PE Ratio data by YCharts

The $4.8 billion Vanguard Midcap ETF (VO) doesn’t use the S&P 400 as its benchmark. The fund has used an MSCI index and is now in the process of shifting to the similar CRSP US Mid Cap Index (the move will lower costs; not that an 0.10% current expense ratio is a heavy burden.). The different benchmark results in a very different portfolio. Vanguard Midcap has just 5.7% invested in the real estate sector, and its forward PE is a below-average 15. That said, the Vanguard ETF’s s 29% price gain over the past five years, trails the 37% rise in the two ETFs that track the S&P 400. That’s a big lag. Then again, 29% is more than double the price return of the S&P 500 over the past five years from a portfolio that has a below-average valuation in an increasing pricey part of the market.

Carla Fried, a senior contributing editor at ycharts.com, has covered investing for more than 25 years. Her work appears in The New York Times, Bloomberg.com and Money Magazine. She can be reached at editor@ycharts.com.

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