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The curious case of US small-cap stocks

The correlation between risk and returns is widely accepted. Historically, smaller companies have often outperformed larger ones over extended periods, a principle deeply embedded in investment theory and practice. However, recent market data has cast doubt on this conventional wisdom.

The Russell 2000 small-cap index, a benchmark for smaller firms, has consistently lagged behind the S&P 500 large-cap index since its inception in 1978, contradicting decades of established trends across various markets. This deviation from historical norms prompts a closer examination of the factors influencing small-cap performance.

Some analysts attribute the underperformance of the Russell 2000 to the dominance of large tech stocks in the current market environment, particularly in the US. However, international markets largely adhere to the traditional small-cap outperformance pattern.

An alternative theory suggests that the indexing methodology itself may contribute to the Russell 2000’s lackluster performance. The formulaic approach of the Russell family of indices allows for predictability, enabling trading firms to exploit index changes and increase volatility during rebalancing periods.

Additionally, shifts in market dynamics, such as the influx of unprofitable companies into the small-cap universe and the growing influence of private equity, have altered the composition and quality of small-cap stocks. These changes, coupled with factors like higher interest rates and increased debt burdens, may further hinder small-cap returns.

Despite these challenges, some analysts maintain optimism regarding small-cap stocks, citing attractive valuations compared to historical averages. However, addressing the fundamental issue of declining quality within the small-cap universe is crucial for sustained outperformance.

In summary, the unexpected performance of US small-cap stocks highlights the intricate nature of financial markets and underscores the importance of continuous analysis and adaptation in investment strategies. While the allure of small-cap investing persists, investors must navigate evolving market dynamics to identify potential opportunities for long-term growth and success.