What are small-cap equities? A detailed summary
Small-cap equities are a distinct asset class, normally making up openly traded business with market capitalizations ranging from $250 million to $2 billion. While they provide considerable growth potential and diversification benefits, they also carry higher volatility, liquidity restrictions, and higher risk compared to large-cap equities. These companies tend to be smaller in scale, typically with younger business models and a strong focus on growth opportunities. They often operate in niche markets, receive less analyst coverage, and experience lower trading volumes relative to their larger counterparts.
Why small caps matter in portfolios
- Growth Potential: Small-cap companies are frequently in early business stages or emerging markets, offering significant room for development and growth.
- Diversification: They provide exposure to a broad selection of sectors and business models, helping to diversify portfolios and minimize concentration risk.
- Alpha Opportunities: Lower analyst coverage and less market efficiency in the small-cap space can create opportunities for skilled investors to identify mispriced securities and generate excess returns when integrated with other asset classes or larger companies.
- Complementary Risk/Return Profile: Including small-cap equities can enhance long-term returns and potentially reduce the frequency of severe drawdowns.
Special Considerations for Small Caps
- Market Structure: The definition and attributes of small caps can vary, and their performance and risk are influenced by factors like liquidity, regulation, and economic cycles.
- Volatility: Small caps are generally more volatile than larger companies, but this risk can be managed through diversification and thoughtful portfolio construction.
- Liquidity: Lower trading volumes in smaller companies can impact trading costs and price stability.
Academic Research
Academic research identifies small-cap equities as a unique asset class due to the “small-cap premium,” which refers to their historical tendency to deliver higher long-term returns compared to large caps, albeit with higher volatility and downside risk. Long-term performance trends (1999-2024): Over a 25-year period (January 1, 1999, to December 31, 2024), the MSCI All Country World Small Cap Index significantly outperformed other indices, ending at 873, compared to 537 for the World Big Cap Index and 561 for the World Broad Index.
Performance Disparity in United States Indices
While the small-cap premium has appeared globally, it has not consistently held in the US market. Over the past 25 years (ending December 31, 2024), the Russell 2000 Index (US small caps) has underperformed the Russell 1000 Index (US large caps). US large caps provided 8.3 percent annualized returns compared to US small caps’ 8.0 percent over the same period.
The gap has widened significantly since 2015, largely driven by the rise of technology mega-caps. Several factors may help explain this divergence:
- Mega-Cap Dominance
- Interest Rate Sensitivity
- Economic Cycles and Investor Sentiment
- The Private Market Impact
Looking Ahead: A Potential Shift?
Against this backdrop, performance data now clearly indicates a divergence between global and US equity trends, where large-cap equities consistently lead the way. While the current environment has been challenging for small caps, there is potential for a shift if interest rates ease and broader economic conditions improve.
Key Takeaways
- Small caps offer strong growth potential and portfolio diversity.
- Market inefficiencies create alpha opportunities for active management.
- Greater volatility and lower liquidity can be managed through diversification.
- Academic research supports a long-term small-cap premium despite higher risk.
- M&A activity can accelerate value creation and recovery for small caps.
- While large caps have recently led the US market, small-cap performance remains tied to economic growth, policy shifts, and valuation trends.
