At a glance 

• The US small- and mid-capitalization (cap) asset class may be an incubator for tomorrow’s biggest companies and has historically rewarded investors for the additional risk taken relative to US large caps. 
• At a time when the US equity market is being led by only a handful of large-cap stocks, today may be an opportune time to consider adding US small- and mid-cap stocks to your equity allocation for the benefits of diversification and an expected improved risk-adjusted return profile. 
• To harness the opportunity in the space, TD Q U.S. Small- Mid-Cap Equity ETF (“TQSM”, the “ETF”) aims to provide exposure to a diversified portfolio of small- and mid-cap US companies. Using a quantitative multi-factor approach, which seeks to optimize exposure to stocks that are expected to outperform the market by emphasizing style factors, TQSM aims to provide strong performance.

US small- and mid-cap equities offer investors a dynamic opportunity set of companies that span from emerging small-cap stocks to former large-cap stocks that have stumbled back to mid-cap land. While many US small- and mid-cap stocks may not be household names in Canada, today’s largest and most recognizable stocks were once small- and mid-cap companies. Apple, Amazon, NVIDIA, and Tesla were all squarely in the US small- and mid-cap asset class at one point. 

We recognize that US small- and mid-caps are not as well represented in investor portfolios in Canada, but an allocation based on an investor’s risk profile and goals may be appropriate given the attractive risk-adjusted return profile the asset class has historically provided. Coupled with the wide variety of US small- and mid-cap funds out there, this article discusses the “why, what, and how” when it comes to investing in US small- and mid-cap equities. 

Why invest in US small- and mid-cap equities? 

Smaller US companies are the lifeblood of the US economy. While they don’t get the same sort of media exposure as Apple or Microsoft, these companies span the gamut from agricultural and construction machinery to airplane parts to specialty chemicals and everything in between. These companies also have a bias toward the strong US economy, and they should benefit from the “onshoring”/”reshoring” of US industries. 

What are the key considerations when investing in small- and mid-cap stocks? 

The small- and mid-cap indices are much more diversified than the large cap S&P 500 Index. The weight of the largest 1 percent of companies within the S&P 500 Index is about 22 percent, which dwarfs the benchmarks used by TD’s small- and mid-cap funds. Similarly, from a sector point of view, the S&P 500 Index is more concentrated in a single sector than the small- and mid-cap benchmarks—the largest sector (Information Technology) within the S&P 500 Index makes up about 29 percent of the overall index. This number jumps to nearly 40 percent if we include companies like Amazon, Alphabet, Meta, and others that were previously classified as Information Technology companies. While the concentration of the S&P 500 Index in just a few companies tends to lead to strong performance when they do well (such as in 2023 with the “magnificent seven”), the index performance can also suffer when they underperform.¹ 

Adding small- and mid-cap stocks to a diversified portfolio can lead to higher returns and lower risk. The graph below shows the efficient frontier for a portfolio consisting of varying weights of the FTSE Canada Universe Bond Index and the MSCI World Index (blue line). Adding a small allocation of small- and mid-cap stocks to this portfolio leads to higher returns and lower risk (green line). For instance, from the chart, a portfolio consisting of 50 percent FTSE Canada Universe Bond Index and 50 percent MSCI World Index has a fifteen-year annualized return of 7.5 percent and an annualized standard deviation of 6.3 percent. Adding a 5 percent weight of small- and mid-cap stocks increases the return to 7.6 percent and decreases the risk to 5.9 percent. 

How are valuations today compared to historical trends? 

Valuations for small- and mid-cap equities tend to be attractive. Historically, small- and mid-cap equities traded at a premium to large-cap equities, reflecting their higher risk/return profile. However, since 2017, the large-cap index has become more expensive, and the gap in valuations between large-cap equities and smaller cap stocks has been increasing (chart below), indicating that smaller stocks are attractively valued compared to their larger peers. Moreover, small- and mid-cap stocks are trading cheaper than their historical multiples.

Solutions from TD Asset Management Inc. 

TQSM aims to provide exposure to a diversified portfolio of small- and mid-cap US companies. By using a quantitative multi-factor approach, which seeks to optimize exposure to stocks that are expected to outperform the market by emphasizing style factors, TQSM aims to provide strong performance. 

Currently, TQSM’s largest factor exposures are to companies with conservative leverage and low-price volatility, companies with profitable and efficient business models and value with a reasonable quality factor. TQSM is also taking a cautious stance on credit risk. TQSM has performed well within this market environment, with returns for all periods up to three years above benchmark.² With less concentration of risk and lower valuations than the S&P 500 Index, along with higher returns and lower volatility than the benchmark, investors could consider adding TQSM to their US equity allocation. 

¹ Source: TD Asset Management. As of January 31, 2024. 3 November 20, 2019. 4 50% 

² S&P Mid Cap 400 Total Return Index (C$), 50% SmallCap 600 Total Return Index (C$). 

Source: TD Asset Management. As of January 31, 2024. 3 November 20, 2019. 4 50% S&P Mid Cap 400 Total Return Index (C$), 50% SmallCap 600 Total Return Index (C$). 

The information contained herein has been provided by TD Asset Management Inc. and is for information purposes only. The information has been drawn from sources believed to be reliable. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment, tax, or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. 

Commissions, management fees and expenses all may be associated with investments in exchange-traded funds (ETFs). Please read the prospectus and ETF Facts before investing. ETFs are not guaranteed, their values change frequently, and past performance may not be repeated. ETF units are bought and sold at market price on a stock exchange and brokerage commissions will reduce returns. 

Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable. Such expectations and projections may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. 

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