U.S. Small Cap Equities: A Strategic and Tactical Opportunity
Spring 2026 | Download PDF
U.S. small cap stocks play a strategic role in portfolios. They offer investors the potential for strong returns, diversification, and—through skilled active managers—long-term outperformance. In addition to these structural advantages, the current market environment appears to be especially favorable to small cap equities. Valuations remain at historic levels and rising IPO and deal activity should be supportive of prices going forward. Small caps are also under-owned after lagging U.S. large cap equities for virtually the entire past decade. Finally, we note that factor performance indicates markets have substantially neglected quality. In past cycles, investor favor has ultimately shifted—an evolution that favors an active, long-term approach. As we detail below, we believe these strategic and tactical reasons make small cap equities a compelling opportunity for investors.
Small Caps: A More Favorable Environment
U.S. small cap stocks have generated strong performance over the past year. Since hitting a low in early 2025, small cap equities have risen sharply and are near multiyear highs.1 U.S. small cap stocks, however, continue to underperform U.S. large cap stocks over the long term, a pattern that dates back more than 10 years. Over a multi-decade timeframe, small and large cap companies have alternated market leadership (Exhibit 1).
The recent outperformance by U.S. large caps, on a monthly rolling 5-year basis, has been historic, and investor allocations to U.S. small cap growth are at their lowest levels in more than a decade (Exhibit 2).
We believe, however, that investors should reconsider small cap equities. Not only can they play a crucial role in portfolios strategically, but several fundamental factors in the current environment appear favorable to U.S. small cap stocks, including:
Relatively Attractive Valuations:
Because smaller cap equities are often seen as offering more upside potential than large cap companies, they have traditionally commanded a higher premium. Since 2021, however, large-cap stocks have had higher valuations and are now near their highest levels of the past 20 years relative to small-cap growth stocks (Exhibit 3).
IPO and Deal Flow Expected to Rise:
Rising business activity and brighter growth prospects are creating a favorable environment for mergers, acquisitions, and IPOs among U.S. small businesses. In 2025, IPO activity surged with 216 new issues4 and raised nearly $48 billion. This was a substantial increase from previous years (176 IPOs in 2024 and 127 in 2023).5 Moreover, private equity remains a key driver of U.S. small cap deal activity and, according to PitchBook, U.S. private equity firms hold about $1 trillion in dry powder. In 2025, private equity deal value reached $1.2 trillion, the highest annual total since 2021.6 With substantial capital available and dealmaking momentum building, U.S. small cap valuations should remain resilient. However, it is important to note that many individual IPOs do not succeed, making skilled active management an important component of small cap investing.
The Active Management Edge in U.S. Small Cap Investing
Active managers have more opportunities to identify market mispricings in U.S. small cap equity markets because they are less researched and have a wider range of characteristics than large cap. Investors can partner with an experienced active manager to add growth potential to their portfolios.
Limited Analyst Coverage Creates Market Inefficiencies
Smaller cap stocks do not have much coverage by Wall Street analysts—and some of them none at all—which makes deep, independent research even more critical.7
U.S. Small Cap Universe Drives Wide Dispersion
With over 2,000 companies represented across indexes, U.S. small cap equities exhibit greater dispersion of returns than U.S. large cap equities (Exhibit 4). The dispersion is the result of the characteristics of small cap companies, which tend to be more influenced by company-specific factors rather than broader market trends. In addition, they typically have lower liquidity and less differentiation within sectors. Large caps, which are more mature businesses, are generally characterized by lower risk and lower upside potential.
A Negative Environment for High Quality
Small cap stocks have rallied since early 2025, but the performance within the asset class has been dramatically uneven. Factor performance indicates that many investors have been neglecting quality. In addition, and even more unusual, the performance of multiple factors hit extreme levels simultaneously. We have rarely seen such stark disparities in factor performance.
In the second half of 2025, the MSCI Barra Earnings Quality factor recorded its lowest six-month return in its 50 years—a history that includes low-quality episodes such as the technology bubble of the late 1990s and the COVID-era meme stock frenzy (Exhibit 5).
Another record-breaking data point was recorded by the Beta factor, which posted a six-month return of 11.4% in the second half of 2025 (Exhibit 6). This performance ranks in the 1st percentile of six-month rolling returns for the factor since 1975. Beta has rarely been more in favor.
Finally, Momentum posted a six-month return of 5.5% in the second half of 2025 (Exhibit 7). This performance ranks in the 6th percentile of six-month rolling returns for the factor since 1975.
These factors illustrate that investors have been neglecting quality in recent markets, especially in 2025. It is also notable that daily trading volume in the stock market has been dominated by algorithmic/quantitative traders, short-term oriented hedge funds, and passive ETF inflows/outflows. The first two market participants tend to favor momentum (i.e., they typically chase winners and sell losers), while the third is buying or selling based on the underlying index or basket the ETF is constructed to mirror. These dynamics can cause many stocks to become divorced from the underlying fundamentals, both to the upside and to the downside, over the short-to-medium term.
Low quality rallies are challenging for active managers because fundamentals are less rewarded and indices rise broadly, leaving fewer winners and losers on which to capitalize. High-quality rallies, however, tend to reward companies on a fundamental basis, thus making it a more favorable environment for skilled active managers with a fundamental, long-term approach.
As extreme as the factor performance has been, it has never been sustainable. Markets typically transition from speculative, momentum-driven phases—where low-quality, high-beta, or narrow leadership in the market is rewarded—to environments where fundamentals, balance sheet strength, and cash flow sustainability reassert themselves. Markets can favor high-beta, story-driven, or cyclical names but, when volatility rises, liquidity often tightens, or earnings dispersion widens, high-quality earners should begin to outperform as investors seek durability, transparency, and reliability.
U.S. Small Caps: A Strategic Allocation and Tactical Opportunity
U.S. small cap stocks have historically delivered outperformance, diversification, and opportunities for active management. Currently, however, we believe the market backdrop for U.S. small caps is favorable for both short- and long-term reasons. Even after recent strong performance, U.S. small caps are under-owned and offer compelling valuations. We also note that, in past cycles, the outperformance of low-quality companies eventually reverts to higher quality.
Finally, small cap companies represent tomorrow’s growth. All successful large cap companies started small, and they can contribute outsized long-term returns to those investors who identify them.
Investors should be aware that small cap investing carries risk. Historically, small caps have been more volatile and have had larger drawdowns than large caps. This makes a long-term investment approach and partnership with a proven active investor, in our view, essential for success.