Despite their recent struggles, small caps are not dead – they are just misunderstanding. After eight consecutive years of underperformance relative to the large cap, some investors are ready to write them completely, even calls for exclusion from portfolio. But the announcement of the death of American Small-Cap Equity is prematurely. History, evaluation metrics, and the position of macro suggests a different story – a one that pointed to a closer return.
This is why it is important to re -release its role in a modern portfolio – not only through the recent performance lens, but now through structural forces working in their favor. In this post, I detect the case to maintain a strategic allocation for small cap in three dimensions: market cycle time, interest rate mobility and relative value.
We still play an important role in the total portfolio strategy for three major reasons:
- All cycles end up
- Interest rates are favorable for small cap
- Small caps are where to find value
All cycles end up
Long-term experience of prolonged underperformance is not uncommon for small-cap stocks, relative to large-caps shares. Prior to the recent cycle, small-cap stocks reduced large-cap shares during the period 1955 to 1962, 1977 to 1978 and 1989 to 2005, with all the exhibits 1. On average, the small-cap vs. larger-cap cycle lasts for about nine years. Now we are in the 12th year of the current cycle, which is historically extended.
Since business stress and geopolitical risks continue to pressurize firms globally exposed globally, focus on small cap stands to focus domestic. These mobility suggests that the current cycle of small-cap underperformance may soon give way for the period of relative power.
Source: Bloomberg. Northern Trust Global Asset Allocation Quantitative Research. Data from January 1, 1930-December 31, 2024. Note: 10-year-old returns are calculated as a 10-year annual total return spread between Russell 2000 and Russell 1000 indices. Prior to 1979, the Return Data S&P 500 index and US Small Caps (Bottom Decile) Total Return Time Series have been downloaded from New York University.
Interest rates are favorable for small cap
My analysis found an important positive long -term correlation (0.6) between the interest rates and small cap or “migrated” in a large cap, as their market capitalization has increased. In the high interest rate environment, small caps migrate at an increased rate, as seen in performance 2. This is important for two reasons: (1) small caps that migrate, are high artists; And (2) High migration rate improves overall small-cap index performance. Unfortunately, the small cap migration rates have declined since 2001, which also coincides with a decline in small-cap performance.
Has the migration rate decline? There is an important fundamental background behind this trend: Easy Money Policy of the decade after the global financial crisis. During this period, the US Federal Reserve fixed the rate of money between 2008 and 2015 and then from 2020 to 2021. Ultra-Low interest rates promoted acquisition activity, and many small-cap firms were acquired by large public firms or private equity investors rather than migrating to large-cap space.
This trend has been reversed – we are seeing an increase in migration rate in recent years. This trend is expected to continue under the new Fed Fund Fund Rate Governance, which is expected to maintain more than 3%interest rates in the next decade.
Source: Bloomberg; Congress Budget Office (CBO). Northern Trust Global Asset Allocation Quantitative Research. From January 1, 1990 to 31 December, 2024, with projection from 2035. The migration rate is calculated from Russell 2000 index as a percentage of moving from Russell 2000 index in each quarter in 1000 index. There is no assurance that any estimate, forecast or launch will be realized.
Small caps are where to find value
My analysis indicates that small cap stock equity universe has a good place to find price and quality. I compared these factors and historical performances between the small cap and the lower the most ranked ranked by quality and size, relatively close to market capitalization for small cap.
Small-cap stocks have demonstrated high quality, as measured by average returns on property of 0.9 (ROA), for the lower quintals of large-cap shares ranked by ROA since 1990 -2.3%. The small cap had more attractive assessment, in which the average value-to-book (P/B) ratio is ratio of 1.66, compared to 2.59 for their large-CAP resonance.
This analysis moves contrary to the ideas of some investors, arguing that only the weakest companies live in small-cap space, while large-cap indices have high quality companies.
My analysis makes this view more disputed if we compare the performance between the small cap and the lower tarsil of the large cap, as seen in the exhibit 3. The small cap improved the smallest big-cap shares since 1990.
1 year | 3 years | 5 year | 10 years | 35 years | |
Russell 2000 | 11.5% | 1.2% | 7.4% | 7.8% | 8.9% |
Russell by market cap below 1000 | 5.5% | -0.3% | 4.9% | 5.2% | 6.3% |
Source: Bloomberg, FactSet. Northern Trust Global Asset Allocation Quantitative Research. The return data is from January 1, 1990 to December 31, 2024. Index performance returns do not reflect any management fee, transaction costs or expenses. It is not possible to invest directly in any index.
key takeaways
- Small-cap is a historical example in underperforms-but the cycles change. We are in the 12th year of a small-cap leggings cycle, which is longer than the average. Historical data suggests that a reversal is near.
- High interest rates are ruling migration. With rates to stay high, small-cap stocks are more likely to graduate in large cap-promoting-promoting the performance capacity.
- Evaluation and quality in favor of small cap. Compared to the weakest segment of the larger cap, the small-cap stock provides strong returns and more attractive value-to-book ratio, unlike the approach that space only has only low quality names in space.
Reference
[1] Evans, Gary, Ziaoli Tang, Juan Korea-Sasa, Felix-Antoine Vejina-Pireer, Chen Zoo, Peter Berezin (2024). The Great Small Cap Hist: How Venture Capital and Big Tech stole America’s best small companies. BCA Research.
[2] Baltusen, Guido, Abhishek Gupta, Daniel Fang (2024). Why small caps are attractive. Northern Trust White Paper.
[3] Fama, Eugene, Kenneth French (2007). Migration. Financial Analyst Journal. Section 63.
[4] Additional information about Economic Outlook: 2025 to 2035. Congress Budget Office, January 30, 2025. https://www.cbo.gov/publication/61135.