High returns have always been the appeal of small-cap funds. They have historically outperformed large-cap funds, providing investors with what has now been called the small-cap premia.
However, small-cap value funds have been underperforming in recent years.
If we focus on the US market, the Russell 2000’s yield-to-date (YTD) of 20.05%, at the time of writing, is lower than the 27.97% returned by the S&P 500.
But this is not an issue unique to 2024. As the chart below from BlackRock shows, the Russell 2000 index has underperformed the S&P 500 index since 2014:
S&P 500 vs. Russell 2000, 2014-2024
Source: Blackrock
In the UK, 2022 was especially a brutal year for small-cap stocks, with the FTSE Small Cap Index falling by 13.6% while the FTSE had a positive return of 4.7%, according to the Financial Times. Investors have not yet recouped the losses they took that year.
The global trend seems to be in line with the USA and UK trends. Looking back at 2023 data, small-cap funds globally underperformed when compared to large-cap funds (17% return to 24%), according to AXA Investment Managers, an investment management company.
They attributed the recent woes of small-cap funds to high interest rates and lower M&A activity.
Given this divergence between historical and current performance, you are probably asking: “Should I invest in small-cap funds?”
The best way to answer this question is to consider if the troubles of small-cap funds are temporary and if there are good fundamental reasons why you should still include them in your portfolio.
To answer that question, we will cover:
- Should you invest in small-cap funds? The reasons investors love them
- Should you avoid small-cap funds? Top concerns about them
- 2025 investment outlook: Key considerations for the future
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1. Should you invest in small-cap funds? The reasons investors love them
Investors have shown interest in small-cap stocks and funds over time because of certain fundamental characteristics that make them attractive. We review these features below:
Potential for higher returns
Companies that are large and stable have little wiggle room for growth while those that are small have a greater tendency to experience high growth rates.
“As a group, these companies are much smaller than their larger-cap counterparts, so they have greater growth potential,” according to Motley Fool, a financial education website. “Under the right circumstances, small caps are a good bet to outperform their larger peers.”
It’s similar to the diverse growth paths of developed and emerging economies. The former are already matured and while growth is stable, it is often small. On the other hand, the latter are in the early stages of their industrialisation and they have more capacity for growth.
Small-cap stocks are usually innovative companies operating in disruptive and emerging niches. For example, four of the top ten best-performing stocks in 2024 are biotechnology companies. When any of their innovations succeed, they often experience very high growth in earnings which translates to capital appreciation.
Another reason for the outsized returns is that small-cap companies tend to reinvest a large portion of their net income back into the business (instead of paying them as dividends) to pursue various growth opportunities.
But do small-cap stocks outperform their long-term counterparts in actual practice?
“Between the end of 2008 and the end of 2023, small caps have outperformed, delivering a cumulative return of 521% against 466% for the large-cap index over the 15-year period,” according to AXA Investment Managers.
This historical outperformance holds in both the US and the UK, according to Sam Benstead, fixed income lead at Interactive Investor. “Dundas Global Investors finds that over the last century, small-caps have outperformed their larger peers by 2.1% a year in the United States, and by 3.2% a year in the UK,“ he writes.
Regarding the US, Blackrock, the investment management company, noted: “U.S. small-cap stocks, typically defined as those with a market capitalization of less than $2 billion, have historically offered higher returns than large-cap stocks over the long term,” they said.
The convergence between what happens to US small-cap stocks and global small-cap stocks is not surprising since US stocks represent about 70% of the global small and mid-cap market cap, according to Canopy Investors, an investment management firm.
This also explains why the focus of the rest of the article is skewed towards the US stock market.
Value investing gems
Value investing thrives on purchasing undervalued companies (the market price of their stocks is lower than intrinsic value) and waiting for the market price to catch up to their intrinsic value.
Many small-cap stocks go under the radar and are often not tracked by stock analysts or owned by institutional investors. This lack of attention makes them undervalued. By buying them cheap, investors can earn a high return on investment (ROI) when they gain traction.
Portfolio diversification
For a portfolio to be diversified, it must contain assets that have a low correlation coefficient with one another. Small-cap stocks have tended to have a low correlation with the general market.
“In an environment where asset classes have become increasingly correlated, small caps have helped diversify portfolios,” according to Raina Oberoi, Managing Director of Research at Morgan Stanley Capital International (MSCI), a finance company.
As seen in the chart below, the correlation coefficient between MSCI USA and World ex USA (both include large and mid-cap stocks) is very high (greater than 0.90).
Correlation Coefficient Between MSCI USA and Different Stock Indices
Source: MSCI
In contrast, the correlation coefficients between MSCI USA and small-cap indices (both World EX USA and emerging markets) are lower.
A study by Morningstar, an investment research firm, also concludes: “Correlations within U.S. equity groups tend to be fairly high, although small-cap stocks tend to have the lowest correlations with the broad market.”
As shown below, Morningstar US Small Growth (0.88) and Morningstar US Small Value (0.87) have the lowest correlations to the Morningstar US Market.
Three-Year Correlation Matrix: US Equity Style Box
Source: Morning Star
Thus, many investors have found it helpful to diversify their portfolios by including small-cap stocks or small-cap funds.
Accessibility
The low prices of small-cap stocks also make them accessible to a variety of investors (especially retail investors).
“The share price of small-cap stocks is often lower, making your initial investment easier,” according to Investopedia, a financial education website. “And share prices can't be artificially pushed up by mutual funds or hedge funds, since there are regulations to prevent financial institutions from investing heavily in them.”
Potential for M&A
Large-cap companies often end up picking up small-cap ones in mergers and acquisitions deals. Often, such M&A deals lead to significant price appreciation in the stocks of small-cap companies.
2. Should you avoid small-cap funds? Top concerns about them
Small-cap stocks and funds have not been without their concerns. Some of the most important ones include:
Volatility
Though they can produce outsized returns, they can also fail since they don’t have the stability of their large-cap counterparts.
“Small caps are also more likely to be unprofitable,” according to Motley Fool. “This makes them more volatile than large caps because they are more vulnerable to recessions, market crashes, and other shocks.”
They gave examples of the COVID-19 pandemic and the 2022 bear market. In those two instances, small-cap stocks (represented by the Russell 2000 index) underperformed compared to large-cap stocks (represented by the S&P 500 index).
Small-Cap Stocks vs Large Cap Stocks During COVID-19
Small-Cap Stocks vs Large Cap Stocks During the 2022 Bear Market
In another article, The Motley Fool noted: “Large-cap stocks tend to outperform small-caps when market volatility, as measured by the CBOE Volatility Index (VOLATILITYINDICES:^VIX), rises.”
The absence of financial stability is one major reason for this volatility.
“Smaller companies react more to volatility in the market because they have less financial cushion than their larger counterparts, according to Investopedia. “As a result, small-cap stocks can see sudden and wide price fluctuations.”
Challenges that stable and mature companies can weather may crush smaller companies that are not as financially buoyant. Also, small-cap stocks often operate in disruptive industries and while some innovations may go mainstream and turn profitable some can stall and become unviable.
Liquidity
Small-cap stocks are not as liquid as their large-cap counterparts. Hence, buyers and sellers may not see their trades executed at desired prices.
Investopedia attributes this low liquidity to the smaller size and lack of popularity of small-cap stocks.
“The smaller size and lower popularity of small-cap companies make their stock less liquid,” they said. “When a company isn't as well-known, it can be harder to find a seller when you want to buy shares. It can also be harder to sell shares when you want to exit the market.”
Information availability
We mentioned that not many stock analysts have their eyes on small-cap stocks. This can make it difficult to find good information that will help you analyse them. In essence, you may have to spend much time getting a good grasp of their fundamentals.
3. 2025 investment outlook: Key considerations for the future
Now that we understand the fundamentals, let’s consider the current situation of small-cap funds and what the future will look like.
Recent large-cap outperformance
Between December 2016 and November 2023, small-cap stocks (represented by the Russell 2000 index) returned 46.25% which is significantly lower than the 130.9% returned by large-cap stocks (represented by the S&P 500 index), according to Pinnacle Advisors.
They attributed this underperformance in the US to high interest rates and declines in M&A activity. The high interest rate environment affects the ability of small-cap companies to raise capital since they depend on floating-rate debt and cannot issue bonds like their large-cap counterparts.
We can even extend this period of outperformance as far back as 2014 in the US, as we saw with the BlackRock chart above, and 2011 with the global market. “Since 2011, global small-caps have underperformed by -1.3% a year,” according to Benstead.
The large-cap outperformance was also noted by Keith Lee, lead portfolio manager on the Brown Capital Management Small Company Strategy, in a June 2024 interview with Morningstar. He noted that while the Russell 2000 Growth has returned a little over 5%, the Russell 1000 Growth has been up about 17%.
Lee attributed this large-cap outperformance to the incredible run of the Magnificient 7 (Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla) and the impacts of high inflation and interest rates on small-cap stocks.
As we have seen, small caps in the UK performed woefully in 2022 and have been underperforming large caps since then. This was attributed to higher debt levels and rising interest rates by Rob Morgan, chief analyst at Charles Stanley, in an interview with the Financial Times.
But this did not start in 2022. “While UK smaller companies have bounced back, they still trail larger UK companies over the past decade,” according to Benstead. Thus, though small caps have historically outperformed over the century, they have not done so over the past 10 years.
Why investors believed in a small-cap recovery
In the early months of 2024, many analysts still held the hope that small caps would once again outperform large caps due to a study of the history of the interaction between both asset classes.
For example, periods of small-cap stocks underperforming large-cap ones have been followed by small-caps outperforming by 22.2%, 10.5%, and 9.8% annually over the subsequent one-, three-, and five-year periods, respectively, according to Pinnacle Advisors.
Lee also noted that small-cap stocks outperform when the market anticipates rate cuts.
“Small-cap generally outperform markets, large companies when there is an anticipation of Fed rate cuts. I think Morningstar has said that the Russell 2000 has risen about 25% during periods of increasing growth and slowing inflation since the ‘70s versus about 17% for the S&P.”
For the past 50 years, small-cap stocks have underperformed large-cap stocks three, six, and 12 months before interest rate cuts while outperforming six months and 12 months after the first cut, according to a Bank of America report referenced by Finimize, a financial institution.
Small-caps vs. large Caps Before and After Interest Rate Cuts
Source: Finimize
Expected interest rate cuts, the breadth and depth of the small-cap universe, and the upward trajectory in financial markets also led Christopher DiPrimio and Travis Cooke, Senior Product Strategist and Portfolio Manager at Systematic Equities, respectively, to expect a positive shift in small-cap performance.
“Recent market dynamics, including shifts in index composition and macroeconomic factors, have fueled large-cap outperformance, but we believe longer-term macroeconomic dynamics are likely to benefit small caps,” they said.
A sign of good things to come?
The small-cap outperformance seemed to have begun in July 2024.
“Through the first half of this year, large caps carried the market,” according to J.P. Morgan, a financial institution. “The S&P 500 and Nasdaq 100 outperformed small caps (Solactive 2000) by more than 16% and 18%, respectively. Since the midpoint, however, the tables have turned. Small caps have rallied over 9%, compared to just over 2% for the S&P 500 and less than 1% for the Nasdaq 100.”
This rally was so significant that the S&P Small Cap 600 outperformed the S&P 500 by 10% (11% to 1%) in July 2024, according to Canopy Investors. As shown below, this was the greatest one-month spread between the two indices since 2020:
US small-cap vs. large-cap, relative 1-month returns, 2000-2024
Source: Canopy Investors
J.P. Morgan attributed this rally to expectations of interest rate cuts, hedge funds’ near-record short position on small caps, and the prediction of a Republican presidency.
That rotation to small-cap stocks did not last, however. Analysts saw it as a preparation for the projected interest rate cut and expected it to hold when the cut finally happens.
True to investors’ expectations, small caps started outperforming large caps days before the first rate cut by the Fed.
“The Russell 2000 index was up for the fifth consecutive session on Tuesday (September 17),” according to Investopedia. “The small-cap benchmark has risen more than 5% in those five days, putting it ahead of the large-cap S&P 500, which has advanced about 2.5%.”
Even then, not all analysts were bullish. While Oxford Economics expected small-cap stocks to be outsized beneficiaries of the anticipated interest rate cuts, Bank of America analysts were sceptical, pointing to the risk aversion in the general market and the weak financial performance of small-cap companies.
The sceptics seemed to have been right.
Small-cap stocks failed to sustain most of their September gains in October. On October 26, Isabel Wang, a reporter for Market Watch, an investment research platform commented:
“For the month (October), small-cap stocks have given back most of their gains from the post-rate-cut rally last month (September) and are down 1% so far in October, while the S&P 500 has gained 0.8% and the Nasdaq has advanced 1.8% in the same period, according to FactSet data.”
Wang attributed this to concerns about inflation rearing its ugly head again, low risk appetite among businesses, uncertainty about the election, and low earnings growth among small-caps.
This has led some investors to stick to large-cap stocks or rotate into mid-cap stocks instead.
The election of Donald Trump would birth another hope for large-cap stocks.
“One recent event that’s helped small-cap value stocks is the election of Donald Trump to a second term as US president,” according to a Morningstar report released on November 29. “The US Market Index is up 3.5% since the election, while the US Small Value Index is up 5.5%.”
Trent Dysert, a portfolio manager at James Advantage, an investment management firm, interviewed by Morningstar attributes this rally to investors’ expectations of lower regulatory burdens, tax cuts, and trade policies favouring domestic manufacturers from a Trump presidency.
Given the number of short-lived rallies we have seen this year, no one knows how long this current one will last.
The situation in the UK
The UK also experienced a significant rally in its small-cap stocks.
“Over the past three months, the FTSE Small Cap index has returned 10%, compared with 3.5% for the FTSE 100 index, which tracks the largest 100 companies on the London Stock Exchange,” noted Benstead on August 6. “Over six and 12 months, smaller companies have also returned more than their larger peers.”
Benstead attributed this to lower interest rates and falling inflation.
Things had flipped a bit by September 30 when the Financial Times, quoted above, noted that “the FTSE Small Cap index has returned nearly 11 percent in the first eight months of 2024, putting it only slightly behind the FTSE 100.”
However, given the index’s performance since 2022, the Financial Times considered this a good development.
Will small caps outperform in 2025?
At this point, it is hard to predict how the “competition” between small caps and large caps will go in 2025.
Everything seems to depend on whether investors have a positive outlook on the economy. If they expect low inflation, more interest rate cuts, and positive economic growth, there might be another (and a more extended) rotation into small caps.
“What we need to see in the next leg, for small caps to have a more continued run, is comfort that the economy is not heading into a calamitous recession, but also that the economy isn’t too hot that it’s going to cause the Fed to reverse course,” said Jordan Irving, small-cap portfolio manager at Glenmede Investment Management, in a phone interview with Market Watch.
The direction that the economy takes after the inauguration of Donald Trump’s presidency will also be a huge factor that will impact the risk appetite of investors.
Low rates combined with business confidence can encourage small caps to invest more and this can boost earnings and lead to a rally in their stock prices.
UK analysts seem to be more confident. The Financial Times expects a recovery in sentiment, new listing, and a return of professional and individual investors to turn the tide towards small caps. Rising consumer confidence and low unemployment were also identified as positive factors for the future of small caps.
“With consumer confidence and business confidence on the up, small-caps offer an attractive opportunity for investors to generate higher returns over the long term,” according to Georgina Brittain, manager of JPMorgan UK Small Cap Growth & Income, quoted by Benstead.
Yet, the UK continues to face a problem of demand for small-cap stocks.
A new report by New Financial, an economic and financial think tank, showed that about 600 small-cap companies have been delisted over the past two decades. One factor they identified is the lack of demand by institutional and retail investors.
“Smaller listed companies have fallen into a self-fulfilling ‘doom loop’ of lower demand, lower valuations, lower performance, higher governance and regulatory requirements, and higher cost, which makes the market less attractive for issuers and investors.”
If such fundamental problems persist, it remains to be seen if temporary relief from lower rates and rising confidence can sustain a long-term rally.
Sometimes, the only thing smart investors can do is to wait. As the year progresses, we expect more clarity regarding these issues.
One thing to do while waiting is to get the feel of other investors and investment experts about the prospect of the global economy in general and the US economy in particular.
At cio investment club, we provide you with a community of asset owners, asset managers, and investment experts with which you can discuss various economic and financial issues.
We also organise exclusive roundtables and investment breakfasts where you can network face-to-face, exchange ideas, and partner on various projects.
Do you want to be part of an investment community where you can discuss issues about the global economy (and particular economies) and how they impact asset classes like small-cap stocks? Register today to become a part of the cio investment club.
Takeaways
- Small-cap stocks appeal to investors due to high growth potential, undervaluation opportunities, portfolio diversification, accessibility, and potential for significant returns in M&A scenarios
- Challenges such as high volatility, lower financial stability, limited liquidity, and sparse analyst coverage make small-cap stocks riskier.
- High interest rates, high inflation, and a drop in M&A activity since 2022 have exacerbated challenges for small-cap funds in recent times.
- Small-cap performance in 2025 depends on economic optimism, including low inflation, further interest rate cuts, and business confidence. Investors are cautiously optimistic but remain uncertain about sustained outperformance versus large caps.
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