For decades, investors counted on the “small-cap premium”, the idea that smaller companies outperformed larger ones over time. But the last 10 years have flipped that script. U.S. small-caps have significantly lagged their large-cap peers, even as non-U.S. markets regained momentum in 2025.
What happened to small caps? The story runs deeper than tariffs or short-term cyclicality. Structural headwinds have reshaped the small-cap universe:
- Quality deterioration: Through July, nearly one-third of Russell 2000 companies were loss-making. Large caps’ valuation premium looks justified by superior profitability.
- IPO market shift: Companies now stay private longer and often debut as large-caps, leaving the small-cap universe older, less profitable, and less dynamic.
- Sector imbalance: Tech is 37% of the Russell 1000 but only 12% of the Russell 2000. Missing out on mega-cap tech’s dominance has cost small caps dearly.
- Rates and debt: Larger firms locked in ultra-low financing years ago, while many small caps are rolling debt at today’s higher yields, eroding earnings power.
Yet it’s not all gloom. Active small-cap managers have quietly outperformed, helped by quality tilts and avoidance of the weakest names. And valuations tell a different story: even when screening only for “quality” companies with ROIC above 20%, small-caps are trading at steep discounts to large-caps.
Long-term capital market forecasts suggest small-caps could outpace large-caps by almost 2% annualized over the next decade. But with balance sheet fragility and uneven profitability still prevalent, investors will need to be selective, either through skilled active managers or systematic strategies that focus on quality and value.
The question is no longer whether small caps are cheap. It’s whether the market has already priced them too low. Are they set for a comeback, or is the “small-cap premium” an idea whose time has passed?
Source: Vanguard
This article is general market commentary, not investment advice or a personal recommendation. The value of investments can fall as well as rise, and past performance is not a guide to future returns. Written and reviewed under our editorial standards.
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