The Small-Cap Premium Was Supposed to Beat Large Caps Over Time. It Hasn't in 15 Years. Here's the Actual Gap.
Key Points
Small-cap stocks have steadily underperformed large caps for more than a decade.
Poor profitability rates and higher interest rates have contributed to the lag.
But improved earnings growth rates and reasonable valuations could be setting up small-cap stocks for an extended stretch of leadership.
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The idea of a small-cap premium goes back decades. The concept is straightforward: Smaller companies carry more risk, and the markets compensate that higher risk with higher long-run returns. It would be the reasoning behind owning something like the iShares Russell 2000 ETF (NYSEMKT: IWM) alongside a large-cap fund, such as the Vanguard S&P 500 ETF (NYSEMKT: VOO).
There's just one problem. With just a few exceptions, that small-cap premium hasn't materialized for at least 15 years.
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The following chart shows small-cap stock performance relative to large-cap stocks over this time frame. If investors were earning a small-cap premium, you'd expect this trendline to be moving up. Instead, it's been trending down for years.
Data by YCharts.
With this type of recent underperformance coupled with an anticipated acceleration in earnings, the opportunity in small-cap stocks could be huge.
Why small caps have lagged large caps for so long
Since the Vanguard S&P 500 ETF launched in 2010, it has gained 830%, far surpassing the 490% return of the iShares Russell 2000 ETF.
There are a few reasons the small-cap premium has disappeared.
- Lower profitability: Roughly 40% of Russell 2000 components are currently unprofitable. More broadly, earnings growth for smaller companies was lower due to higher interest rates, which disproportionately affect debt-heavy small-cap stocks, and the emergence of mega-cap tech as an economic driver.
- Rate sensitivity: Small caps are disproportionately affected by higher interest rates due to higher debt levels to fund operational needs. The U.S. economy went through two major rate-hiking cycles over the past decade.
- Passive fund flows favoring large caps: The growth of index investing, S&P 500 ETFs, and other cap-weighted products has disproportionately pushed a lot of investor capital into just a handful of stocks.
Image source: Getty Images.
Why the small-cap premium could soon return
The macro environment for small caps has begun turning the corner. Megacap tech companies were the first big beneficiaries of the artificial intelligence boom, but now smaller companies are beginning to see the benefits too.
Small-cap earnings are expected to grow 18% in both 2026 and 2027, surpassing the forecasted earnings growth of the S&P 500 for the first time in years. With valuations already considerably lower, the risk/reward profile of small caps looks substantially better today than it did a year or two ago.
We've already seen what can happen when megacaps lose their momentum. The iShares Russell 2000 ETF is outperforming by 8% year-to-date, thanks to improved earnings growth. If large caps begin to see their AI-driven growth rates slow or peak, the rotation into more reasonably valued small caps could continue.
Market leadership goes in cycles. We see it in U.S. vs. international stocks and large caps vs. small caps. Outperformance from one group doesn't last forever. For small caps, the time for a rotation may be approaching.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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