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By Philip van Doorn

You may already have added small-cap and international exposure. Don't forget about midcap stocks.

These are four of the top 10 holdings of the Franklin U.S. Mid Cap Multifactor Index ETF.

Investors holding shares of S&P 500 index funds have been on an excellent ride over the past several years. But with the large-cap U.S. benchmark index at a relatively expensive level to expected earnings and highly concentrated to its largest companies, this might be a good moment to add exposure to other groups of stocks.

One overlooked area to consider is midcap stocks - those of medium-size companies that can get overlooked as investors consider small-cap companies as a counterweight to familiar large caps.

The S&P 500 SPX has returned 100.2% over the past five years through Tuesday, according to data provided by LSEG. All returns in this article include reinvested dividends. That five-year run has made for an average compounded annual return rate of 19%, compared with an average return of 11% over the past 20 years.

Like most broad stock indexes, the S&P 500 is weighted by market capitalization. Its largest 10 companies make up 40.2% of the index, which is close to its maximum concentration of 41.4% at the end of October, according to data going back to 1972 compiled by Ned Davis Research.

Now let's take a look at relative valuations for three broad stock indexes, starting with the large-cap S&P 500:

   Index                       Forward P/E  Forward P/E to 5-year average  Forward P/E to 10-year average 
   S&P 500 Index                      22.1                           110%                            117% 
   S&P MidCap 400 Index               17.3                           110%                            102% 
   S&P Small Cap 600 Index            16.8                           110%                             97% 
                                                                                             Source: LSEG 

These are comparisons of forward price/earnings ratios for the indexes, which are constituent companies' prices divided by rolling consensus 12-month earnings-per-share estimates among analysts polled by LSEG, weighted by market capitalization. It is typical for the mid-cap and small-cap companies as groups to trade at lower P/E valuations than the large caps. All three indexes are trading at 10% premiums to their five-year average forward P/E, but the S&P 500 is by far the most expensive relative to its 10-year average valuation.

There has been some recent movement toward the indexes of smaller companies. From the end of October through Tuesday, the S&P 500 returned 2.3%, while its forward P/E declined to 22.1 from 23.3. Over the same period, the S&P MidCap 400 Index MID returned 7.7% and its forward P/E increased to 17.3 from 16.6. Meanwhile, the S&P Small Cap 600 Index SML returned 9% and its forward P/E climbed to 16.8 from 16.1.

Today we will focus on the midcaps, after recently presenting some alternatives in the small-cap and international spaces for investors looking to add some diversification in their portfolios beyond the S&P 500.

A multifactor approach to midcaps

An investor can use index funds for broad exposure to midcaps with low expenses. One example among several is the State Street SPDR Portfolio S&P 400 Mid Cap ETF SPMD.

Then there are a number of exchange-traded funds that employ factor analysis to narrow down to smaller groups of midcap stocks.

The $1.8 billion Franklin U.S. Mid Cap Multifactor Index ETF FLQM tracks the LibertyQ U.S. Mid Cap Equity Index, which is maintained by FTSE Russell. FLQM is benchmarked to the Russell Midcap Index RMCC, which is made up of the smallest 800 companies in the Russell 1000 Index RUI. The Russell 1000 Index is made up of the largest 1,000 companies in the Russell 3000 Index RUA, which itself is designed to include 98% of the market for publicly traded stocks listed in the U.S.

Being benchmarked to the Russell Midcap Index gives FLQM more exposure to "smaller large names" compared with the S&P MidCap 400 Index, according to Todd Mathias, the head of U.S. ETF product strategy at Franklin Templeton.

During an interview with MarketWatch, Mathias described FLQM's strategy as "active by design but passive by implementation." He said the ETF was "a natural way" for an investor to diversify with a strategy "entrenched in high-quality companies with healthy balance sheets and fair or attractive valuation profiles."

He said the stock methodology was "something on the order of how an investor would select stocks on their own."

The fund's underlying index is reconstituted twice a year after the Russell Midcap Index is reconstituted in June and November. FTSE Russell applies four factors to the 800 stocks in the Russell Midcap Index to aim for lower price volatility and better long-term performance than that of the benchmark.

The four factors and their percentages within the index provider's scoring methodology are:

• Quality (50%), which incorporates profitability metrics, such as return on equity, cash return on assets and gross-margin sustainability.
• Value (30%), which encompasses companies' forward earnings yields, based on consensus estimates and share prices, price/book ratios, dividend yields and Ebitda to enterprise value.
• Momentum (10%) takes into account price movement over the preceding six and 12 months.
• Low volatility (10%) measures price volatility relative to that of the Russell Midcap Index.

Using the combined factor scores, the underlying index is narrowed down to about 200 stocks, with the fund rebalancing its portfolio quarterly to account for corporate actions such as mergers or the issuance of additional shares.

Largest holdings

When the Franklin U.S. Mid Cap Multifactor Index ETF is reconstituted twice a year, its portfolio of about 200 stocks has a maximum weighting of 1% for each. So the following list of the fund's largest 10 holdings reflects price increases since it was last reconstituted or rebalanced.

Franklin Templeton discloses the fund's holdings daily. These were FLQM's largest 10 holdings as of Tuesday:

   Company                           % of FLQM portfolio 
   Ulta Beauty Inc.                         1.2% 
   Dollar General Corp.                     1.2% 
   Old Dominion Freight Line Inc.           1.2% 
   Monolithic Power Systems Inc.            1.2% 
   Tapestry Inc.                            1.2% 
   Cummins Inc.                             1.2% 
   EBay Inc.                                1.1% 
   W.W. Grainger Inc.                       1.1% 
   Sysco Corp.                              1.1% 
   Fastenal Co.                             1.1% 
                               Source: Franklin Templeton 

Fund performance

The Franklin U.S. Mid Cap Multifactor Index ETF was launched in April 2017. It is rated four stars (out of five) within Morningstar's U.S. Fund Mid-Cap Blend category.

The fund's expense ratio is 0.30% of assets, which means annual fees would come to $30 for a $10,000 investment.

Here is a comparison of the fund's performance for several periods through Dec. 31 relative to index funds tracking the Russell Midcap and S&P MidCap 400 indexes, followed by five fund peers tracking either of those indexes listed by LSEG. After FLQM and the two broad index funds, the last five are sorted by 10-year average annual returns, and then by average five-year or three-year returns, depending on when each fund was launched.

Returns are net of expenses. You might need to scroll the table or flip your screen to landscape to see all of the data.

   Exchange-traded fund                                2025 return  3-year avg. return  5-year avg. return  10-year avg. return  Expense ratio Launch date 
   Franklin U.S. Mid Cap Multifactor Index ETF                5.4%               12.2%                9.6%                    -          0.30%  4/26/2017 
   iShares Russell Mid-Cap ETF                               10.4%               14.2%                8.5%                10.8%          0.18%  7/17/2001 
   State Street SPDR Portfolio S&P 400 Mid Cap ETF            7.5%               12.5%                9.1%                10.4%          0.03%  11/8/2005 
   Fidelity Enhanced Mid Cap ETF                             12.1%               16.3%               10.9%                11.3%          0.23% 12/20/2007 
   First Trust Active Factor Mid-Cap ETF                      9.9%               16.7%               11.1%                    -          0.65%  12/3/2019 
   Inspire Growth ETF                                        16.1%               17.4%                7.8%                    -          0.80%  12/7/2020 
   Argent Mid Cap ETF                                        -1.4%               13.5%                   -                    -          0.52%  8/16/2022 
   BBH Select Mid Cap ETF                                    -5.6%                9.8%                   -                    -          0.84%  5/24/2021 
                                                                                                                                               Source: LSEG 

Net expense ratios are shown. These match the funds' full expense ratios in all cases except for the Inspire Growth ETF GLRY, which has a full expense ratio of 0.96%. This is being limited by the fund's investment adviser to 0.80% until at least March 31.

FLQM outperformed the iShares Russell Mid-Cap ETF and the State Street SPDR Portfolio S&P 400 Mid Cap ETF for the five-year period but underperformed most of the funds listed here for the one-year and three-year periods.