Despite their recent struggles, small caps aren’t dead — they’re just misunderstood. After eight consecutive years of underperformance relative to large caps, some investors are ready to write them off entirely, even calling for exclusion from portfolios. But declaring the death of US small-cap equities is premature. History, valuation metrics, and macro conditions suggest a different story – one that points to an approaching comeback.
That’s why it’s critical to reassess their role in a modern portfolio — not just through the lens of recent performance, but through the structural forces now working in their favor. In this post, I explore the case for maintaining a strategic allocation to small caps across three dimensions: market cycle timing, interest rate dynamics, and relative value.
US small caps still play a critical role in a total portfolio strategy for three key reasons:
All cycles end
Interest rates are favorable for small caps
Small caps are where to find value
All Cycles End
It is not unusual for small-cap stocks to experience prolonged periods of underperformance relative to large-cap stocks. Prior to the recent cycle, small-cap stocks underperformed large-cap stocks during the periods 1955 to 1962, 1977 to 1978, and 1989 to 2005, all seen in Exhibit 1. On average, the small-cap vs. large-cap cycle lasts about nine years. We are now in the 12th year of the current cycle, which is historically extended.
As trade tensions and geopolitical risks continue to pressure large, globally exposed firms, domestically focused small caps stand to benefit. These dynamics suggest the current cycle of small-cap underperformance may soon give way to a period of relative strength.
Source: Bloomberg. Northern Trust Global Asset Allocation Quantitative Research. Data from January 1, 1930–December 31, 2024. Note: 10-year return spread is calculated as rolling 10-year annualized total return spread between Russell 2000 and Russell 1000 Indices. Prior to 1979, return data is based off S&P 500 Index and US Small Caps (bottom decile) total return time series downloaded from New York University.
Interest Rates Are Favorable For Small Caps
My analysis found a significant positive long-term correlation (0.6) between interest rates and small caps moving up or “migrating” to large caps as their market capitalization increases. In higher interest rate environments, small caps tend to migrate at an increased rate, as seen in Exhibit 2. This is important for two reasons: (1) small caps that migrate tend to be higher performers; and (2) higher migration rates tend to improve overall small-cap Index performance. Unfortunately, small- cap migration rates have declined since 2001, which also coincided with declining small-cap performance.
What caused the migration rate to decline? There is a key fundamental backdrop behind this trend: the decade-long easy money policy following the global financial crisis. During this period, the US Federal Reserve set the funds rate near zero between 2008 and 2015 and again from 2020 to 2021. Ultra-low interest rates fueled acquisition activity, and many small-cap firms were acquired by larger public firms or private equity investors rather than migrating into the large-cap space.
This trend is reversing – we are observing an uptick in the migration rate in recent years. This trend is likely to continue under the new fed funds rate regime, which is expected to maintain interest rates above 3%, over the next decade.
Source: Bloomberg; Congressional Budget Office (CBO). Northern Trust Global Asset Allocation Quantitative Research. Data from January 1, 1990 to December 31, 2024, with projection to 2035. Migration rate is calculated as the percentage of market cap moving from Russell 2000 Index into Russell 1000 Index each quarter. There is no assurance that any estimate, forecast or projection will be realized.
Small Caps Are Where to Find Value
My analysis indicates small cap stocks are a good place to find value and quality in the equity universe. I compared these factors and historical performance between small caps and the bottom subset of large caps ranked by quality and size, which are relatively close in market capitalization to small caps.
Small-cap stocks have exhibited higher quality, as measured by an average return on assets (ROA) of 0.9, versus -2.3% for the bottom quintile of large-cap stocks ranked by ROA since 1990. Small caps had more attractive valuations, with an average price-to-book (P/B) ratio of 1.66, compared to 2.59 for their large-cap counterparts.
This analysis runs contrary to the views of some investors, who argue that only the weakest companies remain in the small-cap space, while large-cap indices contain higher-quality companies.
My analysis further disputes this view if we compare performance between small caps and the bottom tercile of large caps, as seen in Exhibit 3. Small caps consistently outperformed the smallest large-cap stocks since 1990.
Source: Bloomberg, FactSet. Northern Trust Global Asset Allocation Quantitative Research. Return data is from January 1, 1990, to December 31, 2024. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index.
Key Takeaways
Small-cap underperformance has historical precedent — but cycles turn. We’re in the 12th year of a small-cap lagging cycle, longer than average. Historical data suggests a reversal is near.
Higher interest rates are reigniting migration. With rates expected to stay elevated, small-cap stocks are more likely to graduate to large caps — boosting overall performance potential.
Valuation and quality favor small caps. Compared to the weakest segment of large caps, small-cap stocks offer stronger return on assets and more attractive price-to-book ratios, contradicting the view that only low-quality names remain in the space.
References
[1] Evans, Garry, Xiaoli Tang, Juan Correa-Ossa, Felix-Antoine Vezina-Poirier, Chen Xu, Peter Berezin (2024). The Great Small Caps Heist: How Venture Capital and Big Tech Stole America’s best small companies. BCA Research.
[2] Baltussen, Guido, Abhishek Gupta, Daniel Fang (2024). Why Small Caps are Attractive. Northern Trust White Paper.
[3] Fama, Eugene, Kenneth French (2007). Migration. Financial Analysts Journal. Volume 63.
[4] Additional Information about the Economic Outlook: 2025 to 2035. Congressional Budget Office, January 30, 2025. https://www.cbo.gov/publication/61135.
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