Marvel at the Middle for Rising Rates Protection

With 10-year Treasury yields still on an uncomfortably torrid pace higher, it's starting to feel like there's nowhere to hide in the equity markets.

As seasoned advisors well know, cyclical assets historically perform well when rates rise. That's supportive of some sectors and dividend-paying names. In theory, surging 10-year Treasury yields benefiting cyclical stocks should also be constructive for smaller stocks, though recent price action on the Russell 2000 and S&P SmallCap 600 indexes suggest otherwise.

Still, rising rate environments can be conducive to embracing mid caps – easily the most overlooked corner of the equity market. Data confirm that assertion. If we are to believe that rising 10-year yields are the primary “drag” on domestic stocks in the first quarter, it's worth pointing out the S&P MidCap 400 Index is up 12.1% year-to-date, nearly double the 6.2% returned by the large-cap S&P 500.

To be fair, mid caps are lagging small caps to start 2021, but advisors should remind clients of two things. First, when allocating to broad benchmark strategies, long-term is the name of the game. Second, mid caps' track record against their smaller rivals is enviable and impressive.

“In the months in which small-cap returns were positive, mid caps outperformed nearly 40% of the time,” according to Boston Partners research. “Overall, mid caps outpaced small caps 53% of the time. Th is demonstrates that a key element of mid caps’ strong historical relative performance has been their tendency to preserve capital in down markets.”

Mid Caps' Rising Rates Utility

As clients are learning this year, the sector classifications of cyclical, defensive and economically sensitive are meaningful.

Morningstar designates consumer discretionary, financial services and real estate as the cyclical groups. That's pertinent for mid caps against the backdrop of rising rate because the S&P MidCap 400 allocates over 46% of its combined weight to those sectors.

Add value to the equation – a potentially potent idea given that value is heavily cyclical and proving enthralling this year – and the weights of that quartet of sectors jump to almost 57% in the S&P MidCap 400 Value Index. In fact, mid-cap value is a compelling combination in nearly setting.

“Mid-cap value has been one of the most consistently performing asset classes over the last 25 years,” according to WisdomTree. “Despite the relentless underperformance of the value factor since the mid-2000s, mid-cap value has held up much better than its large- and small-cap counterparts. In fact, mid-cap value has beaten the S&P 500 Index on 63% of all rolling 3-year periods, 76% of rolling 5-year periods, 97% of rolling 10-year periods, and on every single rolling 15- and 20-year period.”

Surprising Durability

It would take some time and credentials I don't have to explain why market participants – both professional and retail – consistently gloss over mid caps.

However, advisors looking to convince clients this asset is worthwhile have plenty of fuel.

“In summary, mid caps have performed better than large caps in rising markets and have been less volatile than small caps when stock prices are falling,” notes Boston Partners. “In this way, U.S. mid caps provide both upside capture and downside protection relative to other segments of the market.”

Those are the facts and they look pretty good.

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