The stock market is off to a rocky start in 2022. Some shares have fallen more than others: Exhibit 1 shows how small caps have lagged large caps in 2021 and into 2022, at least when measured using Russell indices. However, a deeper look shows a subset of small-cap stocks drove much of this underperformance. Small companies with high stock prices that lose money or generate little profit may be holding back your small-cap portfolio.
Tech’s Slice of the Pie: Large Caps vs. Small Caps
Take a peek under the hood of large-cap and small-cap indexes, and you’ll quickly spot a key difference: technology’s influence is far more pronounced among the giants. In the S&P 500, technology stocks make up about 30% of the index, giving them a major role in driving overall performance. But if you shift your gaze to the Russell 2000—a favored small-cap barometer—tech stocks represent just 10%. That’s quite a gap.
What does this mean for your portfolio? When tech is leading the market (think artificial intelligence, cloud computing, or software booms), large-cap indexes tend to surge ahead—carried by their extra helping of tech heavyweights like Microsoft, Apple, and Nvidia. Small-caps, with their lighter tech exposure, don’t benefit as much from tech-driven rallies.
On the flip side, if technology stocks stumble or cool off, that heavy concentration can work against large caps, potentially giving small caps a relative advantage—so long as other sectors such as financials, health care, or industrials (categories where small caps have more weight) are holding their own. But if those sectors aren’t firing on all cylinders, small caps may still lag, regardless of what’s happening in tech.
Growth of wealth, Russell 1000 vs. Russell 2000
Profitability Differences Among Small-Cap Indexes
Not all small-cap indexes are built the same, especially when it comes to profitability requirements. Take the S&P SmallCap 600 and the Russell 2000, for example. The S&P 600 screens for profitability—companies must meet certain earnings criteria to be included. In contrast, the Russell 2000 simply includes the smallest 2,000 stocks from its broader universe, regardless of whether those companies are making money.
This key distinction means that, at a given point (for instance, mid-April), a much larger share of Russell 2000 constituents report negative earnings compared to the S&P 600. So, if you’re looking at small-cap performance or risk profiles, it’s worth considering how the index’s ground rules might affect the mix of rising stars and unprofitable upstarts in your portfolio.
How Rising Borrowing Costs Hit Small-Cap Companies Harder
Small-cap companies tend to face greater headwinds when borrowing costs increase. Unlike larger firms, many small caps are still struggling to consistently turn a profit, which can make them more reliant on taking out loans to keep operations running or to pursue growth. When the Federal Reserve hikes interest rates, borrowing becomes pricier for everyone—but the pinch is tighter for small caps.
Why? Because banks and lenders typically see small caps as riskier bets than their large-cap cousins. This means that not only do small companies start off paying higher interest rates, but rising rates amplify the effect. And, since small-cap loans often have shorter maturities, these companies have to refinance their debt more frequently. That exposes them to fluctuating rates and makes budgeting more challenging when rate hikes are frequent.
In practice, this means many small caps could spend a bigger chunk of their cash flow just servicing debt. For investors, that’s an extra risk to watch—especially if a large portion of a small-cap company’s loans are coming due in the near term.
The top detractors to the Russell 2000 Index performance in 2021 share a common trait: they have low to negative profits and trade at high relative prices. At the beginning of 2021, each of the five companies charted in Exhibit 2 had generated negative profits over the previous year and traded at price-to-book ratios that placed them in the highest relative price quartile of the market.
Top five detractors to the Russell 2000 Index return in 2021.
Investor Sentiment and Sector Spotlight: The Underlying Drivers
A closer look at small-cap returns reveals that investor behavior often hinges on trends and shifting enthusiasm for particular sectors. In recent years, technology has commanded the spotlight, with much of the market’s excitement—and investment dollars—gravitating toward artificial intelligence and related innovations. This tech fervor has heavily influenced large-cap performance, since technology makes up a much bigger slice of those indices than it does in the small-cap universe.
For small-cap stocks, the story plays out a bit differently. Tech is a smaller constituent here, so wild swings in sentiment toward technology have a muted impact on small-cap benchmarks. Conversely, sectors such as financials, health care, and industrials make up a much larger share of small-cap indices like the Russell 2000. When investors lose their enthusiasm for tech and start looking elsewhere, small caps may get a boost—but only if these key sectors are also enjoying favorable sentiment and healthy fundamentals.
If investors remain cool on those core small-cap sectors, even a pullback from tech may do little to benefit small-cap performance overall. This sector balance—paired with investor appetite or skepticism—plays a crucial role in determining not just which companies lead or lag, but how small-cap stocks stack up against their larger-cap peers.
Looking more broadly, we can see negative 2021 returns across many small caps with low profitability—particularly growth stocks with low profitability, as shown in Panels A and B of Exhibit 3.
These stocks were the worst-performing segment by far among small caps in 2021. This follows a four-year streak when these names outperformed other small caps, which led some investors to wonder whether looking to valuation and profitability to make investment decisions was outmoded.
Spotlight on Key Sectors: Beyond Tech in Small Caps
When evaluating small-cap performance, it’s not enough to focus solely on the high-flying names in technology. A large portion of the small-cap universe resides in sectors like financials, health care, and industrials. These areas are fundamental for broad small-cap benchmarks such as the Russell 2000.
Financials—think regional banks and specialty lenders—often represent a significant slice of the index. Their performance can have an outsized impact, especially during periods of economic change or shifting interest rates. Health care companies, from biotech innovators to medical device manufacturers, also make up a substantial portion. Finally, industrial firms—ranging from machinery producers to logistics operators—add another important layer. When these three sectors are thriving, the broader small-cap market tends to find firmer footing.
But when financials, health care, and industrials struggle, the challenge multiplies. Even if sentiment shifts away from tech, weakness in these crucial sectors can act as a headwind for small caps overall, making it harder for the index and corresponding funds to stand out.
How Elevated Inflation Challenges Small Caps
Rising inflation and higher labor costs have taken a toll on small-cap earnings over the past year and a half. Unlike established household names—think Coca-Cola or Procter & Gamble—many smaller, lesser-known companies simply don’t have the pricing power to pass increased expenses on to their customers.
So, when wages rise and input prices jump, small caps tend to absorb those costs rather than offsetting them with higher revenues. The result? Squeezed profit margins and, for many, declining earnings estimates. This revenue-to-expense mismatch has made it especially tough for small caps to keep pace with their larger peers during recent inflationary periods.
The Impact of Moderating Inflation on Small-Cap Sentiment
Inflation cooled off in 2024, and with it, interest rates have edged lower as well. This shift offered some relief to small-cap stocks, especially when it comes to their earnings forecasts. With less pressure from rising costs and borrowing rates, the downward revisions to earnings estimates that plagued small caps were less severe.
But there’s a catch. Investors remain cautious. A brief pause in inflation isn’t enough to spark widespread enthusiasm for small caps, especially when compared to large caps whose profits have weathered economic turbulence far better. What the market is really looking for now is clear, sustained improvement in small-cap earnings—not just temporary tailwinds from softer inflation numbers. Until that happens, investor sentiment is likely to keep favoring bigger, more resilient companies.
How Lower Interest Rates Could Benefit Small-Cap Companies
So, what role do interest rates play in all this? Lower interest rates can offer a welcomed tailwind for small-cap companies. Here’s why: smaller firms often rely more heavily on borrowing to fund their operations and growth than their larger, more established peers. With cheaper access to capital, it becomes less costly for these companies to finance new projects, expand, or simply weather tougher economic environments.
This isn’t to say that a drop in rates is a cure-all. Even with lower borrowing costs, small-cap companies must still grow their earnings at a healthy clip to truly capitalize on the opportunity. However, an improved rate environment certainly eases some of the pressure—making it easier for these businesses to invest in themselves, bring new ideas to market, and potentially boost their bottom lines over time.
Debt Maturities and Small-Cap Stocks: A Potential Risk?
One factor casting a longer shadow over small-cap stocks relates to the timing of their debts coming due. Unlike their large-cap counterparts, many smaller firms must refinance or repay a greater portion of their existing debt within the next few years. This compressed schedule means small-caps are more sensitive to rising interest rates. If borrowing costs increase as their debt reaches maturity, these companies could face higher expenses just to maintain operations—putting even more pressure on already thin profit margins.
For investors, it’s an important dynamic to monitor: companies forced to refinance at unfavorable rates may see reduced earnings or, in severe cases, liquidity strain. This is yet another reason to take a hard look at the fundamentals—like profitability and balance sheet strength—when sizing up small-cap opportunities.
However, looking broadly across decades of returns in global markets, we observe that small-cap growth stocks with low profitability tend to underperform over the long run. And for good reason. From a valuation perspective, paying a lot for a company that earns little profit is a good sign of a very low discount rate, and therefore a low expected investor return. Research has shown that when examining stocks by their size, price-to-book, and profitability characteristics, small-cap stocks with the lowest profitability and highest relative price have experienced the lowest historical returns. (1) By seeking to avoid these stocks, one can improve the expected return of a small-cap portfolio. Commenting on the body of research examining these stocks, Professor Robert Novy-Marx said, “The small unprofitable growth portfolios are … way less than the sum of their parts. They just do so badly in the data.”(2)
Navigating Small-Cap Index Funds and ETFs: Upsides and Pitfalls
While maintaining exposure to small-cap stocks can enhance portfolio diversification, investing through small-cap index funds or ETFs comes with a mix of potential rewards and notable risks.
Benefits of Small-Cap Index Investing
Diversification: Small-cap index funds and ETFs provide broad exposure to hundreds or even thousands of smaller companies, helping to smooth out the impact of any single firm’s disappointing performance.
Potential for Growth: Historically, small caps have delivered periods of strong returns, especially when economic conditions favor nimble, innovative businesses.
Lower Barriers to Entry: These vehicles allow investors to access an entire swath of the market—without the challenge of picking individual stocks or worrying about liquidity.
Risks to Consider
Quality of Holdings Varies: The composition of small-cap indices differs greatly. For example, as of mid-2022, the Russell 2000 included a much larger share of unprofitable companies (about 44%) compared to roughly 20% for the S&P SmallCap 600, which has a profitability screen for inclusion. This means not all small-cap indices are created equal, and some may expose investors to more speculative stocks.
Volatility: Small-cap stocks are generally more volatile than their larger counterparts. Index funds and ETFs tracking these companies can experience sharper declines during market downturns.
Potential for Misleading Index Performance: Indices that are less selective about financial health may lag during challenging periods, as showcased by recent underperformance driven by unprofitable growth stocks.
Choosing Wisely
When selecting a small-cap index fund or ETF, examine the index’s methodology:
- Does it require profits for inclusion (as with the S&P SmallCap 600)?
- Is it more inclusive but potentially riskier (as with the Russell 2000)?
- Look beyond the name—review the underlying index rules and the overall mix of companies represented.
By being mindful of these factors, investors can harness the diversification potential of small caps while managing exposure to segments that have historically dragged on returns. Dimensional seeks to avoid these stocks in our portfolios that invest in small caps, such as those shown in Exhibit 4. And while this is not the only way our small-cap funds may seek to add long-term value, 2021 adds another year to our long-run track record of delivering small-cap solutions that have outperformed both peers and index funds.
How Government Policies Shape Small-Cap Performance
Shifts in government policy—like changes to deregulation or tariff structures—can play a significant role in the fortunes of small-cap companies. For example, when regulations are rolled back, smaller businesses often benefit since they typically don’t have the same resources as larger firms to absorb compliance costs. In that sense, easing the regulatory burden gives these companies some welcome breathing room and a chance to become more competitive.
However, policy changes can cut both ways. Tariff uncertainty, for example, introduces new challenges. Smaller, more domestically focused businesses tend to feel the pinch quickly if costs go up or if supply chains get tangled. With fewer buffers to absorb sudden shocks, these companies may find it tough to adjust, especially compared to their larger, more globally diversified counterparts.
In short, while deregulatory initiatives can lend a tailwind to small caps, the turbulence from new tariffs or erratic trade policies may offset those gains—reminding investors that small companies are especially sensitive to the policy winds blowing through the market.
FOOTNOTES
- See Eugene F. Fama and Kenneth R. French, “A Five-Factor Asset Pricing Model,” Journal of Financial Economics 116, no.1 (2015): 1-22.
- “Episode 149: Professor Robert Novy-Marx—The Other Side of Value,” May 13, 2021, in Rational Reminder, podcast.
- Average Index Fund Placement is provided where index fund(s) with a Morningstar 1 or 10-Year Total Return Absolute Category Rank exist in the category as of the period ending date.
GLOSSARY
Price-to-book ratio (P/B): The ratio of a firm’s market value to its book value, where market value is computed as price multiplied by shares outstanding and book value is the value of stockholder’s equity as reported on a company’s balance sheet.
This information is not meant to constitute investment advice, a recommendation of any securities product or investment strategy (including account type), or an offer of any services or products for sale, nor is it intended to provide a sufficient basis on which to make an investment decision. Investors should consult with a financial professional regarding their individual circumstances before making investment decisions.
Risks include loss of principal and fluctuating value. Investment value will fluctuate, and shares, when redeemed, may be worth more or less than the original cost. Small-cap investments are subject to greater volatility than those in other asset categories.