How to Play the Broadening of the U.S. Market: Rotate to Mid and…

U.S equities delivered strong performance in the first half of 2024 with the mega-cap “Magnificent 7” stocks leading the way. The S&P 500 is currently up about 19% year-to-date, and the Mag 7 now account for about 30% of the index.¹This concentration risk presents investors with a unique opportunity to diversify into stocks with smaller market capitalizations. Small cap equities have been trading at a discount relative to their larger-cap counterparts, and as the market’s rally broadens and interest rates appear poised to fall, small- and medium-cap stocks are expected to play catch up.

ETFs in Focus

Benefits

Exposure to diversified U.S. medium- and small-cap equities
Designed for investors looking for growth solutions
Falling U.S. interest rates amid steady economic conditions may provide tailwind

According to JP Morgan, the forward price-to-earnings ratio on small cap U.S. equities has fallen to lows last seen in early 2000s (see chart below). The current forward P/E ratio provides a potentially attractive entry point ahead of another possible rally.

On a relative valuation basis, P/E ratios across the S&P Mid Cap 400 and S&P Small Cap 600 indexes are 15.24 and 14.45, respectively — well below the ratio for the benchmark S&P 500, which sits currently at 21.²

Forward P/E Ratio: Small Cap Stock Relative to Same Cohort of Large Cap Stocks

Historically, falling interest rates have provided a tailwind for equities. Current market expectations put the chances of a rate cut from the U.S. Federal Reserve in September at 93%.³ The commencement of rate cuts provides a tactical opportunity to rotate into mid- and small-cap stocks as smaller companies that have a greater reliance on debt and floating rates relative to large caps benefit from easing financial conditions. Furthering the case for the rotation, earnings growth has been spreading from large caps to medium- and smaller-size companies as the market continues to broaden out. Finally, U.S. small- and mid-caps have benefitted from the size equity premium historically, outperforming the S&P 500 in the long run (see chart below).⁴

Historical Outperformance of S&P Small/Mid-Cap Indexes vs. S&P 500 Index

For investors seeking to capitalize on the potential for mid and small caps to break out, here are some ways to play the broadening of the market:

BMO S&P US Mid Cap Index ETF (Ticker: ZMID)

Diversified exposure to the top 400 US mid-sized companies screened for liquidity and quality. To put the sheer size of the S&P Midcap 400 & 600 indices into perspective, the index market capitalization sizes are larger than Canada and South Korea’s entire equity market, respectively.

Index Market Capitalization Size

A key characteristic of BMO’s mid- and small-cap ETFs is a profitability screen that is applied by the index, which filters out for low quality. Stocks are screened by the underlying index for a positive net income on a trailing 12-month and most recent quarter basis. This is an important step to help filter out certain risks associated with mid and smaller cap companies.

Mid cap companies have successfully navigated the challenges specific to smaller public companies, such as raising capital and managing early growth, often having established infrastructure, access to financing and distribution systems making them more stable relative to small caps.
Management Fee: 0.20%

BMO S&P US Small Cap Index ETF (Ticker: ZSML)

Diversified exposure to the top 600 U.S. small-cap companies, with an index-level screen for liquidity and profitability. Not all small caps are created equal so investors will need to be discerning in which small caps to invest in, considering the risks of leverage and weaker earnings relative to large caps.
The Russell 2000 is a common way for investors to get exposure to small caps, however due to unique methodology, including the profitability screen within underlying index used by ZSML, it has outperformed the Russell 2000 by 1.7% annualized since 1995.
Gain an exposure to companies that may be on the leading edge of innovation and potential for market growth into larger mid caps, and eventually into a stock that could enter the S&P 500.
ZMID and ZSML offer additional sector diversification exposure to further lower a portfolio’s correlation to the broader S&P 500, due to higher weights in Industrials, Financials and Real Estate.

Mid & Small Caps Sector Weighting

Management Fee: 0.20%

Large caps have the size and scale to withstand a potential economic slowdown, which can still be possible in the medium-term. Investors should be aware smaller cap companies by contrast are more vulnerable to macro risks and a weaker consumer.

However, investors with a longer-term investment horizon, quality small- and mid-cap stocks offer not only the prospect for long-term growth, but also the potential for portfolio diversification from investing across the market-cap spectrum, particularly for investors who have already gained from mega-cap stock exposure and have a greater percentage of their equity portfolio invested in large-cap stocks. Allocating a satellite position in an overall equity portfolio to small- and mid-cap stocks, assuming an appropriate time horizon and risk tolerance, can be beneficial to long-term risk-adjusted returns.

Historical Performance

Fund	Ticker	1-Year	2-Year	3-Year	Since Inception
BMO S&P US Small Cap Index ETF	ZSML	11.89%	12.08%	2.61%	7.55%
BMO S&P US Mid Cap Index ETF	ZMID	16.86%	18.66%	7.49%	10.10%

Source: BMO Global Asset Management, June 30 2024. The inception date for both the BMO S&P US Small Cap Index ETF and BMO S&P US Mid Cap Index ETF was February 5, 2020.

¹BMO Global Asset Management, June 30, 2024

²JP Morgan/S&P Dow Jones, as of June 30, 2024

³CME FedWatch Tool, June 30, 2024.

⁴Size risk premium is the additional return investors expect to earn from small-cap stocks compared to large-cap stocks. Small-cap stocks are generally riskier, and therefore investors demand a higher return to compensate for additional risk.

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How to Play the Broadening of the U.S. Market: Rotate to Mid and Small Caps