Despite their recent struggle, the little hats are not dead – they are just misunderstood. After eight consecutive years of inadequate performance compared to the large cap, some investors are fully prepared to write them down, seeking exclusion from the portfolio. However, it is too early to declare the death of a US small cap. History, rating indicators, and macro conditions suggest different stories.
That’s why it’s important to reassess their role in our modern portfolios, not just through the lens of recent performance, but also through the structural forces that are currently working in their favor. In this post, we explore cases where we maintain strategic allocations to small caps across three dimensions: market cycle timing, interest rate dynamics, and relative value.
The US small cap still plays a key role in its comprehensive portfolio strategy for three key reasons.
- All cycles are finished
- Interest rates are advantageous for small caps
- A small cap is where you find value
All cycles are finished
It is not uncommon for small caps to experience a period of long performance compared to large caps. Before the recent cycle, small caps did not perform large stocks during the period 1955-1962, 1977-1978, and 1989-2005. It is now the 12th year of the current cycle and has been historically expanded.
Trade tensions and geopolitical risks continue to put pressure on large, globally exposed companies, so small domestically focused caps are profitable. These dynamics suggest that current low-cycle cycles of small caps will soon give way to periods of relative strength.
Source: Bloomberg. Northern Trust Global Asset Allocation Quantitative Study. Data from January 1, 1930 to December 31, 2024. Note: The 10-year return spread is calculated as the 10-year total annual revenue spread between the Russell 2000 and Russell 1000 Index. Before 1979, the return data was based on the S&P 500 index and US small cap (bottom dikyle) total revenue time series downloaded from New York University.
Interest rates are advantageous for small caps
In my analysis, as interest rates rose or “moving” to a larger cap, a significant positive long-term correlation (0.6) increased between interest rates and small caps rose or “moving”. In a higher interest rate environment, small caps tend to rise, as seen in Figure 2. This is important for two reasons. (1) Small moving caps tend to be higher performers. (2) The higher the mobility, the better the overall small index performance. Unfortunately, since 2001, the movement rate of small caps has also declined, which coincided with a decline in small cap performance.
What caused the decline in mobility? There is an important fundamental background behind this trend. A simple money policy that lasts for ten years following the global financial crisis. During this period, the US Federal Reserve set a funding rate close to zero between 2008 and 2015 and 2020 and 2021. Ultra-low interest rates promoted acquisition activities, with many small businesses being acquired by large public companies or private equity investors rather than migrating to large cap space.
This trend is reversed. We have observed an increase in transition rates in recent years. This trend could continue under the new Fed fund 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 Study. Data from January 1, 1990 to December 31, 2024 in projections on 2035. The transition rate is calculated as a percentage of the market capitalization that moves from the Russell 2000 Index to the Russell 1000 Index in each quarter. There is no guarantee that estimates, predictions, or predictions will be realized.
A small cap is where you find value
My analysis shows that small caps are a good place to find value and quality in the fairness universe. We compared these factors and historical performance between small caps and the lower subset of large caps ranked by quality and size.
Small caps show higher quality, as measured by average return on assets (ROA), compared to -2.3% in the lower quintile of large caps ranked by ROA since 1990.
This analysis is contrary to the views of some investors. Some investors argue that large indexes include high quality companies, whereas only the weakest companies remain in the small cap space.
My analysis further challenges this view when comparing performance between the small cap and the tersil at the bottom of the large cap, as seen in Figure 3.
| 1 year | 3 years | 5 years | 10 years | 35 years | |
| Russell 2000 | 11.5% | 1.2% | 7.4% | 7.8% | 8.9% |
| Russell 1000 bottom tersil by market capitalization | 5.5% | -0.3% | 4.9% | 5.2% | 6.3% |
Source: Bloomberg, Fact Set. Northern Trust Global Asset Allocation Quantitative Study. Return data is from January 1, 1990 to December 31, 2024. The performance returns for the index do not reflect administrative fees, transaction costs, or expenses. You cannot invest directly in the index.
Key takeout
- There is a historic precedent for small cap underperformance, but the cycle changes. We are in our 12th year of a small, late cycle, for longer than average. Historical data suggests that the reversal is near.
- Higher interest rates are rekindling the transition. Small caps are likely to graduate to a big cap, increasing the overall performance potential as interest rates are expected to rise.
- Rating and quality favor small caps. Compared to the weakest segment of large caps, small caps offer a stronger return on assets and a more attractive price-measure ratio, contradicting the view that only low-quality names remain in the space.
reference
[1] Evans, Gully, Shari, Xiaoli Tang, Juan Correa-Ossa, Felix-Antoine Vezina-Poirier, Chen Xu, and Peter Berezin (2024). Great Small Cap Heist: How venture capital and big technology stole America’s best small businesses. BCA research.
[2] Baltossan, Guido, Abhishek Gupta, and Daniel Fan (2024). Why are small caps so attractive? Northern Trust White Paper.
[3] Fama, Eugene, and Kenneth French (2007). transfer. Financial Analyst Journal. Volume 63.
[4] Additional information on economic outlook: 2025-2035. Congressional Budget Office, January 30, 2025. https://www.cbo.gov/publication/61135.
