Since the middle of November 2025, the small cap Russell 2000 index has returned around 15%, more than double the gain of its larger brethren, the benchmark S&P 500 and the technology-focused Nasdaq Composite indices.
This is not just a US phenomenon but has an international dimension. For instance, the MSCI Global small cap index has also outperformed the global index.
Likewise, here in the UK the FTSE AIM 100 index has bested the FTSE 100 index over the same period.
What factors could drive further outperformance?
Further interest rate cuts are expected in 2026 from major central banks as inflation continues to abate. As we explain later, this removes a major headwind for smaller companies.
Research by Goldman Sachs Asset Management noted: “Given that US small caps represent over 60% of the global small-cap market, the anticipated US rate cutting cycle is poised to meaningfully influence small-cap performance globally.”
Secondly, a broad cyclical economic recovery is expected to support faster earnings growth for smaller domestic firms over larger international ones, which, combined with their lower valuations could support further rotation into small caps.
Analysts at Bank of America project 19% earnings growth for small caps in 2026, which is higher than the mid-teens consensus growth expectation for the S&P 500 index.
This dynamic is not reflected in valuation metrics with small caps trading at their widest PE (price to earnings) discount to large caps in around two decades.
With US large caps arguably priced for perfection amid high concentration in the Magnificent Seven names, small caps could attract further interest from investors.
Not everyone is convinced that the small cap rotation has legs. Seasonal factors could be at play with small caps often outperforming in January only to fade as the year progresses.
Why have small caps underperformed?
The biggest drag on performance has been rising interest rates.
This is a big deal because smaller companies are more sensitive to rising interest rates. They tend to carry greater amounts of debt, and they often pay more to service debt due to their weaker balance sheets.
The rising interest rate environment between March 2022 and July 2023 also had a dampening effect on corporate takeovers which relied on debt financing. For example, deal volumes in the UK declined by around 17% according to data by PwC.
Private equity groups, historically a significant buyer of small caps, pulled back from deals due to higher finance costs while smaller companies found it harder to raise capital.
Ways of getting exposure to small caps
Smaller companies are riskier investments and therefore for many investors using funds is a good way to achieve diversified exposure.
Passive options include the iShares MSCI World Small Cap UCITS ETF, which is the largest fund by assets to track the underlying MSCI index. It has an annual charge of 0.35% a year.
The ETF replicates the index by buying a selection of the most relevant index constituents. Dividends are accumulated and reinvested in the ETF.
The £5.7 billion fund invests globally across more than 3,400 companies in developed equity markets.
The largest ETF tracking US small caps is the SPDR Russell 2000 Small Cap UCITS ETF which has £3.7 billion of assets and an annual charge of 0.3% a year.
The ETF buys a selection of the most relevant index constituents and dividends are reinvested.
In Europe the largest small cap ETF is the Xtrackers MSCI Europe Small Cap UCITS ETF which has £2.4 billion of assets and an annual charge of 0.3%.
What about active funds?
It is worth highlighting that because smaller companies tend to be less researched, theoretically there is more potential for fund managers to find hidden bargains.
The downside is that active funds have higher charges and there is no guarantee the manager will outperform the benchmark.
The WS Gresham House UK Smaller Companies Fund features on the AJ Bell favourite funds list, which is a curated selection of funds designed to help investors narrow down their research.
The Gresham House investment team is made up of five professionals and headed up by private equity veteran Ken Wotton. The team look to harness their private equity experience within public markets,
The managers leverage their large network of external contacts which bring in-depth insights into various industries. The portfolio consists of around 40 individual stocks with a particular focus on companies with a market capitalisation between £250 million and £1 billion.
The £381 million fund has an annual charge of 0.82%.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
