Small-cap stocks have long been pitched as the place to find tomorrow's market winners. Yet they've spent the past decade trailing their larger rivals, and the reasons go well beyond a rough stretch for smaller businesses. With interest rates climbing again, the case for a comeback is getting harder to make.
Higher rates hit smaller companies harder
Smaller businesses often need to borrow to fund their growth, which makes rising interest rates particularly painful. The Federal Reserve delivered its first rate hike in three years in September, while 10-year and 30-year Treasury yields climbed to their highest levels in over a decade.
The timing is especially difficult for small caps. They have a greater proportion of debt coming due over the next four years than large companies, leaving more of them facing potentially expensive refinancing.
Larger companies have another advantage. They can issue long-term bonds to lock in borrowing costs, while smaller firms rely more heavily on bank loans and private credit, often with floating interest rates.
Small caps missed the AI boom
Wall Street's enthusiasm for AI has created another problem for smaller stocks. Technology accounts for roughly 30% of the S&P 500 but just 10% of the Russell 2000, leaving small caps with far less exposure to the companies driving much of the market's gains.
Average annual return over the past decade (%)
Russell 2000 small caps versus S&P 500 large caps, per Charles Schwab.
Bar chart. Average annual return (%). S&P 500: Average annual return (%) 13%. Russell 2000: Average annual return (%) 7.90%.
The performance gap tells the story. Over the past decade, the Russell 2000 delivered average annual returns of 7.9%, compared with 13% for the S&P 500, according to Charles Schwab.
The best startups aren't going public
Small-cap indexes are also missing out on businesses that might once have fueled their growth. Promising companies are staying private longer, while private investors have enough capital to keep funding them without a stock market listing.
Meanwhile, acquisitions are taking existing public companies off the market. The result is a smaller pool of potential winners and a Russell 2000 increasingly populated by businesses with weaker financial profiles.
That comes with greater risk. Since 1991, the Russell 2000's average peak-to-trough decline has been 3.7 percentage points deeper than the S&P 500's.
Why the public small-cap pool is thinning
Structural pressures on small-cap index quality identified by Morningstar research.
| Factor | What the research found |
|---|---|
| Later listings | High-growth companies stay private longer |
| Take-privates | Public companies bought out at higher prices |
| Index mix | Russell 2000 skews toward very small, lower-quality stocks |
| Downturns | Average drawdown 3.7 points deeper than large caps since 1991 |
Smaller firms also have fewer competitive advantages to protect their profits when business conditions deteriorate. Morningstar sees this decline in company quality as a major reason small caps have struggled, rather than a problem that will disappear with the next economic recovery.
Where small caps still fit
None of this means investors should abandon smaller companies altogether. But it does make a case for being more selective rather than buying the entire Russell 2000 and waiting for a rebound.
One alternative is the S&P SmallCap 600, which requires companies to meet profitability standards before joining. That gives the index a quality advantage over broader small-cap benchmarks.
Smaller stocks can also help diversify a portfolio, particularly if the market's biggest companies begin to struggle. And their recent performance isn't quite as disappointing when measured against their own history.
Acadian Asset Management found that the Russell 2000's Sharpe ratio, which measures returns relative to risk, averaged around 0.40 over the past decade, compared with 0.39 since 1995.
In other words, small caps haven't performed unusually badly by their own standards. Large caps have simply done much better. Investors waiting for that gap to close may need more than lower interest rates, especially when some of the strongest growth opportunities are no longer reaching the public market.
