NBK Wealth Thought Leadership: Small-Cap Equities as an Asset Class: A Comprehensive Overview

What Are Small-Cap Equities?
Small-cap equities are a distinct asset class, typically comprising publicly traded companies with market capitalizations[1] ranging from $250 million to $2 billion. While they offer significant growth potential and diversification benefits, they also carry higher volatility, liquidity constraints, and greater risk compared to large-cap equities. These companies tend to be smaller in scale, often with younger business models and a strong focus on growth opportunities. They frequently 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 often in early business stages or emerging industries, offering significant room for growth and innovation.
• Diversification They provide exposure to a broad array of sectors and business models, helping to diversify portfolios and reduce 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.
• Complementary Risk/Return Profile Including small-cap equities can enhance long-term returns and potentially reduce the frequency of severe drawdowns when combined with other asset classes or larger companies.

Unique Considerations for Small Caps

• Market Structure: The definition and characteristics 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 and the Small-Cap Premium

Academic research recognizes 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 greater volatility and downside risk. Pioneering research by Eugene Fama and Kenneth French[2] has extensively documented this outperformance, often attributed to market inefficiency in valuing smaller companies and the higher risk associated with their operations.

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 Large Cap Index and 561 for the World Broader Index. Small-cap equities delivered annualized returns of 8.57% versus 6.22% for large-cap equities, but with higher volatility (18.04% standard deviation for small caps vs. 15.69% for large caps) and deeper maximum drawdowns (-56.74% for small caps vs. -53.96% for large caps). Despite these risks, small-cap equities showed faster recovery from drawdowns (24 months vs. 53 months for large caps).

Table 1. Annualized Performance and Risk Metrics and Comparative Analysis (1999-2024)

Morningstar data and NBKW MSR-CIO Office Analysis. Indices are MSCI All Country World Indices. Data as of 31 Dec 2024.

Performance Disparity in US Indices

 While the small-cap premium has been evident 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 delivered 8.3% annualized returns compared to US small caps’ 8.0% over the same period. This gap has widened significantly since 2015, largely driven by the rise of technology mega-caps.

Table 2. US Equity Indices Trailing returns (large cap vs. small cap)

Morningstar data and NBKW MSR-CIO Office Analysis. Indices are Russell 2000 & 1000 USD Total Return indices. Data as of 31 Dec-2024.

Several factors could help explain this divergence…

• Mega-Cap Dominance: Much of the Russell 1000’s outperformance has been driven by a handful of massive technology and growth companies, often called the “Magnificent Seven[3]”, whose size and rapid growth have had an outsized impact on large-cap index returns. This concentration effect is less pronounced in global markets and among small caps.
• Interest Rate Sensitivity: Small-cap companies tend to rely more on debt financing, making them more vulnerable to rising interest rates. As borrowing costs increase, smaller firms often experience a squeeze on profitability and growth prospects, while larger companies, typically with stronger balance sheets, face fewer financial constraints.
• Economic Cycles and Investor Sentiment: Small businesses are more exposed to domestic economic shifts, supply chain disruptions, and inflation. During periods of economic uncertainty, large multinationals with diversified revenue streams tend to be more resilient. Additionally, risk-averse investors increasingly favor the perceived stability of mega-cap companies, further contributing to small-cap weakness.
• The Private Market Effect: Many promising growth companies are choosing to stay private for longer, delaying their entry into public markets. This trend reduces the number of high-growth companies available in small-cap indices, which may further diminish their attractiveness.

Looking Ahead: A Potential Shift?
Against this backdrop, performance data now clearly indicates an alignment 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. The prevailing view suggests that if interest rates ease and broader economic conditions improve, small-cap equities could stand to benefit. This environment may result in lower borrowing costs, a stronger earnings outlook, and potentially increased merger and acquisition activity, creating opportunities for renewed growth within this segment.

Key Takeaways:

• Small caps offer strong growth potential and portfolio diversification.
• Market inefficiencies create alpha opportunities for active management.
• Higher volatility and lower liquidity can be managed through diversification.
• Academic research supports a long-term small-cap premium despite greater 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 correlated with economic growth, policy shifts, and valuation trends.

[1] Total value of a company based on its current share price.

[2] Fama and French (1992) identified the small-cap premium, showing small-cap equities’ historical outperformance over large caps.

[3] The “Magnificent Seven” companies include Apple, Microsoft, Nvidia, Amazon, Alphabet, Meta, and Tesla.

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