why are small cap stocks underperforming? Causes & outlook

This article explains why are small cap stocks underperforming, reviewing the evidence, principal drivers (valuation, profitability, rates, sector mix, liquidity), investor implications and metrics...

2025-11-19 16:00:00

By Alex Carter

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Why Are Small‑Cap Stocks Underperforming?

why are small cap stocks underperforming is a question many investors have asked since large‑cap indices began to outpace small‑cap benchmarks over a sustained multi‑year period. This article summarises the evidence, explains the main economic and structural drivers, and outlines practical implications and indicators investors can monitor. It is intended to be beginner‑friendly while grounded in industry reports and indexed evidence.

As of January 15, 2026, according to Vanguard’s report "Fading small‑cap premium and softer U.S. labor market" (2025), the small‑cap cycle shows persistent divergence from the historical size premium. As of January 10, 2026, Charles Schwab (2025) and Wellington Management (2025) likewise document extended relative weakness for small‑cap indices versus large caps.

Definition and scope

Small‑cap refers to publicly traded companies with relatively small market capitalizations. In U.S. equity market practice, common benchmarks include the Russell 2000 and the S&P SmallCap 600. When we ask "why are small cap stocks underperforming," we mean small‑cap total returns (price appreciation plus dividends) versus large‑cap benchmarks such as the Russell 1000 or the S&P 500 over multi‑year rolling periods.

This article focuses primarily on U.S. equities, where the underperformance has been most visible in recent years, but it also touches on international contrasts (developed ex‑US and emerging markets).

Historical context — the small‑cap premium

Academic research beginning with Fama and French identified a historical "size premium": over long periods, smaller companies tended to deliver higher average returns than larger companies, after controlling for risk factors. That historical pattern has been cyclical — small caps have outperformed in some regimes and lagged in others.

Importantly, the long‑run size premium is not guaranteed and can be interrupted for extended stretches. The current cycle of small‑cap underperformance is notable because it lasted longer and coincided with structural market changes (see sources: Morningstar 2024, Vanguard 2025, CFA Institute 2025).

Evidence of recent underperformance

Simple empirical observations support the claim that small‑cap indices have lagged large caps:

Relative performance spreads: Over the multi‑year period following 2021, small‑cap indexes such as the Russell 2000 trailed the S&P 500 and Russell 1000 by sustained margins documented in industry reports (Morningstar indexes analysis, 2023; MarketWatch charts, 2025).
Valuation gaps: Analysts reported material forward P/E and price/book discounts for small caps relative to large caps; several 2025 research notes place the forward P/E spread in double digits percentage points in favor of large caps (Vanguard 2025; Charles Schwab 2025).
Profitability divergence: Aggregate profitability metrics (ROIC, operating margin, percentage of profit‑making firms) have declined more for small caps than for large caps, increasing the fundamental justification for lower valuations (Morningstar 2024; AllianceBernstein 2025).

As of January 12, 2026, Wellington Management (2025) highlights that multi‑year price performance and earnings momentum have favored large, high‑quality firms while small caps show weaker earnings trends and lower analyst coverage.

Principal explanations for underperformance

Structural changes in the small‑cap universe

One major driver is structural: high‑growth companies now often remain private longer and are frequently acquired before they reach larger market caps. This selection effect reduces the flow of higher‑quality companies into the small‑cap indices.

Private capital (venture and private equity) and increased M&A activity remove some potential winners from public small‑cap universes. As of late 2025, several industry notes (CFA Institute 2025; AllianceBernstein 2025) point to a thinner pipeline of IPOs and higher takeout activity compared with previous decades.

Sector composition and market concentration

Large‑cap indices have been led by a narrow group of mega‑cap firms and secular winners in technology, communications services and select consumer categories. Small‑cap indices typically have less exposure to these high‑return secular growth names and more weight in cyclical and old‑economy sectors (energy, industrials, regional banks, smaller retail names).

When mega‑cap tech outperforms, it boosts large‑cap indices and widens the gap. Morningstar (2024) and MarketWatch (2025) show how sector leadership differences can explain a significant share of the performance gap.

Interest‑rate and credit sensitivity

Higher interest rates can disproportionately pressure small firms. Small companies more often have shorter debt maturities, higher borrowing costs, thinner cash buffers and lower interest‑coverage ratios. When policy rates rise or stay elevated, discount rates on future earnings increase and refinancing becomes costlier — a larger relative hit for smaller firms.

As of January 14, 2026, Charles Schwab (2025) noted that rate cycles have been a consistent explanatory variable in recent small‑cap weakness, particularly for loss‑making or highly leveraged companies in the index.

Profitability and quality deterioration

Industry analysis documents a rise in the proportion of loss‑making companies within small‑cap indices and weaker aggregate returns on invested capital (ROIC) versus large caps. Lower profitability supports lower valuations.

Morningstar’s 2024 review quantified meaningful divergences in margins and ROIC across size cohorts, and AllianceBernstein (2025) emphasized how quality differences help explain sustained valuation discounts.

Inflation and input costs

Periods of higher inflation and stronger wage growth tend to compress margins for firms with limited pricing power. Small firms often have less ability to pass on higher input costs compared with larger brands, increasing sensitivity to inflation shocks and contributing to relative underperformance.

Investor behavior and flows

Passive investment flows have concentrated into large‑cap benchmarks through cap‑weighted index funds and ETFs. Performance chasing and the search for perceived safety or liquidity also tilt allocations toward large caps in times of uncertainty. Lower asset flows into small‑cap funds reduce demand and can depress relative prices over time.

Reports from 2024–2025 (Morningstar; Quent Capital; Lord Abbett) document persistent fund outflows or underallocation to small caps during the recent underperformance cycle.

Market microstructure and liquidity

Reduced analyst coverage, higher bid‑ask spreads, and lower free‑float liquidity make small caps more vulnerable to selling pressure. Fewer market participants and limited secondary market depth can amplify price moves and widen discounts versus better‑covered large caps.

Collectively, these explanations interact: structural supply changes, sector leadership, higher rates, weaker fundamentals and flow dynamics together create an environment where small caps underperform.

International comparisons

The small‑cap underperformance trend is most acute in the U.S., where tech mega‑caps dominate market capitalization and private capital markets are deep. Other regions have exhibited different patterns: in some developed ex‑US markets or selected emerging markets, small caps have outperformed when domestic cyclical recovery or commodity strength favoured smaller firms.

CFA Institute (2025) and Morningstar indexes (2023) note these regional differences and caution against assuming a universal small‑cap weakness story across all countries.

Valuation, expected returns, and the investment case

Where valuations of small caps trade at a discount to large caps, investors must decide whether the gap reflects an opportunity (over‑discount) or appropriate compensation for higher risk and weaker fundamentals.

Analysts in 2025 reported sizable forward P/E and price/book spreads; interpretation depends on expected earnings, default risk, and macro scenarios. If small‑cap profitability and growth expectations improve, current discounts could presage higher expected returns. If not, discounts may be structural.

Implications for investors and portfolio strategies

Strategic allocation and diversification

Small‑cap exposure has historically offered diversification and higher long‑term expected returns, but it also raises volatility and idiosyncratic risk. For long‑term investors, maintaining a strategic allocation to small caps can preserve intended risk‑return characteristics, provided allocation is consistent with risk tolerance and time horizon.

Tactical and factor tilts

Given the varied quality within small caps, many investors tilt toward quality (profitability, ROIC), value, or momentum within small‑cap universes to capture upside while managing downside. Morningstar (2024) and Quent Capital (2025) highlight that quality screens can reduce drawdown risk and improve active‑manager outcomes.

Active vs. passive management

Evidence suggests that active small‑cap managers with disciplined selection and quality bias have, at times, outperformed passive small‑cap strategies, particularly when index compositions include a higher share of low‑quality firms. AllianceBernstein (2025) and Lord Abbett (2025) discuss scenarios where active selection can add value.

Risk management and credit monitoring

Practical steps include monitoring debt maturities, interest‑coverage ratios, and sector concentration. Investors with small‑cap exposure should pay attention to macro shifts (rates, growth, inflation) that disproportionately affect smaller firms.

Potential catalysts for a reversal

Several developments could favor small caps and narrow the performance gap:

Falling interest rates, which reduce discount rates and ease refinancing costs for smaller firms.
Broadening market leadership as mega‑cap dominance wanes or as cyclical sectors recover.
Improving macro growth that bolsters cyclical revenues and margins for smaller companies.
Stronger IPO activity and fewer private‑market takeouts, increasing the supply of public small‑cap growth candidates.
Signs of earnings revisions and upgrades concentrated in small‑cap sectors.

Wellington Management (2025) and CFA Institute (2025) identify several of these catalysts in their recent commentary and view a multi‑variable shift as the likely trigger for a durable small‑cap recovery.

Data and metrics to monitor

Useful indicators for tracking small‑cap health include:

Relative performance spread: rolling return gaps between Russell 2000 and Russell 1000 or S&P 500.
Valuation spreads: forward P/E and price/book ratios for small caps versus large caps.
Profitability trends: aggregate ROIC/ROE, operating margins, and the percentage of index constituents that are loss‑making.
Debt metrics: median debt maturities, interest‑coverage ratios and leverage measures for small‑cap cohorts.
IPO activity and aggregate primary market issuance.
Index concentration: number and weight of mega winners in large‑cap indices versus small‑cap breadth measures.
Fund flows: net flows into small‑cap ETFs and mutual funds versus large‑cap equivalents.

As of January 12, 2026, Morningstar (2024) and Multiple 2025 industry notes encouraged investors to track these indicators to form an evidence‑based view of whether discounts are narrowing or structural headwinds persist.

Criticisms and alternative explanations

There are alternative views. Some analysts argue the underperformance is a rational repricing: small caps now face genuinely higher risk due to leverage, lower profitability and weaker growth prospects. Others emphasize structural market evolution — deep private capital markets and faster M&A — that change the public small‑cap cohort. Timing matters: over shorter horizons, these forces can dominate, while longer horizons may still reward size exposure.

Quent Capital (2025) pushes back against claims that small caps are permanently impaired, arguing they are misunderstood and may offer opportunity for selective investors. Lord Abbett (2025) and AllianceBernstein (2025) offer nuanced perspectives emphasizing quality and active selection.

Notes

This article is observational and synthesises industry reports and index analysis. Multiple explanations interact and the empirical outcome depends on the time horizon and macro regime. The content is for informational purposes and does not constitute investment advice.

When readers consider tradable instruments or want to track markets, Bitget offers market data and wallet solutions for digital assets; for equity market research and brokerage decisions, consult regulated brokers and research providers. Explore Bitget resources to learn more about market access and research tools.

How to monitor the question "why are small cap stocks underperforming" for your portfolio

Actionable steps for a reader who wants to monitor the situation without making investment decisions immediately:

Set up a watchlist comparing a small‑cap index (e.g., Russell 2000) and a large‑cap index (e.g., S&P 500) with rolling 1‑, 3‑ and 5‑year returns.
Track valuation spreads (forward P/E and price/book) monthly.
Monitor fund flows into small‑cap ETFs and mutual funds.
Review IPO pipeline and M&A activity affecting small‑cap universe.
Watch macro indicators that matter for small caps: real rates, credit spreads and growth indicators.

For more tools and market data, explore Bitget’s research hub and the Bitget Wallet for secure custody of your digital assets. These resources can support broader portfolio monitoring alongside your equity market research.

Finally, to answer the central phrase plainly one more time: why are small cap stocks underperforming? Because a combination of structural supply changes, sector leadership that favors large‑cap secular winners, higher interest‑rate sensitivity, deteriorating profitability in the small‑cap cohort, weaker investor flows and liquidity constraints has produced a multi‑year relative weakness. Whether this underperformance reverses depends on many moving parts: rates, macro growth, IPO activity, and earnings momentum.

If you want, I can expand any section into a deeper, data‑driven appendix with charts and the specific indexed numbers from the referenced reports, or produce a one‑page executive summary that highlights the top five data points and investor‑level actions.

The content above has been sourced from the internet and generated using AI. For high-quality content, please visit Bitget Academy.