Why US small-caps have seen an uptick in fortunes

US large-caps have been the unparalleled leader in equity market returns and investor inflows to the detriment of its small cap peers. But as the global market order shifts US small caps are showing signs of a revival.

Globally, small caps have struggled over the past five years, with higher interest rates and inflation creating a headwind to this more economically sensitive part of the market.

The MSCI World index tracks the biggest global companies and made almost 70% total returns since 2021, meanwhile MSCI World Small Cap made 37%.

This disparity is even greater when you focus just on the US, with the S&P 500 chalking up gains of almost 80%, which the Russell 2000 managed a return of just 21%.

Bill Hendon, manager of the First Eagle US Small Cap Opportunity fund, says since he started out in the sector 25 years ago the past four to five have been “very very difficult”, made even more painful with an drought of initial public offerings (IPOs) due to the extremely volatility in equity markets.

Over five years, IA North American Smaller Companies funds have averaged a return just under 20% ranking 27th out of 55 sectors. By contrast, IA North America came in fourth with a 43% average.

But now the tide may have begun turn. The performance of small-cap funds has been improving.

In Q1 2026, the IA North American Smaller Companies sector bested its large-cap counterpart and this hasn’t just been a flash in the pan, with the trend holding up over a volatile 12 months.

While past performance is not a guarantee of future returns, examining which parts of the market are exhibiting a change in investment performance is worth diving into, especially when it shows early signs of some sustained positive momentum.

Some US rate cuts may still be on the table 

As mentioned, small-caps are more sensitive to the economic health of the country they’re based in and the cost of borrowing is a major factor since these companies usually take on a higher level of debt than large-caps.

And while the outlook for US rate cuts has dampened since the start of the year following the outbreak of war between the US and Israel and Iran, Kirsty Desson, Aberdeen Global Small Companies manager, said there was still scope of some rate cuts albeit, not as many as initially forecast. “But [even] say two cuts would still be a positive dynamic,” she says.

While other developed economies might even increase rates this year if inflation becomes stickier this would make the US, including its small cap contingent, more attractive on that front too.

What matters more though is the forecast rate of economic growth and the US has been incredibly bullish on getting its domestic growth engine going, an ideal dynamic for small caps.

This doesn’t mean they’re not vulnerable to the threat of inflation due to the Iran conflict, but Olivia Micklem, co-manager of Artemis US Smaller Companies fund, explained that today this subset of the market is in better shape than it was back in 2020 and 2022 when similar macro headaches helped shake out unprofitable names which had been propped up by the previously low borrowing costs.

She explained that the market reached an IPO fever pitch in 2021 after a backlog was created by the pandemic and companies delayed their listings, but many which were unable to scale, leading to 40% of the Russell 2000 being unprofitable.

“But of that 60%, you can get some really brilliant companies,” she says. Noting they have healthier balance sheets and diversified supply chains.

Why a pro-business policy agenda is good for small caps

Underpinning all of this, the sector has benefited from a wave of pro-business polices enacted by the White House, which could feed into more domestic corporate activity, changes which have flown somewhat under the radar amid the headline grabbing international agenda of President Donald Trump.

This has sparked a business migration trend, with companies moving from more corporate tax heavy States such as California to more accommodative areas such as Texas, colloquially referred to as ‘Y’all Street’.

The ‘Big Beautiful Bill’ also brought in a lot of fiscal stimulus for domestic firms and “that really kicked in at the beginning of 2026”, Nathan Moser, manager of the Impax Small Cap fund says.

This policy support from the government is feeding into the market Aberdeen’s Desson says, “and that is providing pockets of investment in certain areas, particularly around infrastructure”.

IPOs and M&A

IPOs and M&A are a big part of the small-cap space and all the managers we spoke to for this article note that the post-2020 drought had begun to end. 

While small caps carry a connotation of being lesser-known names, many in the US are globally known brands. In fact, the average size of a Russell 2000 company is around $5 billion. For comparison, the average size of a companies within the MSCI UK Small Cap Index is approximately £1.5 billion. 

This also means US small caps can often aim higher than their global peers when it comes to M&A, seen recently with Victory Capital putting in a challenger bid against private equity manager Blackstone for asset manager Janus Henderson. 

Nathan Moser, whose Impax Small Cap fund invests in Victory Capital, says that when he started out a US small cap was typically a $2 billion company, now he’s looking for $10 billion firms most of the time. 

Domestic firms with international recognition in this category include office supply chain Staples and beauty brand e.l.f, which recently bought rival Hailey Bieber’s skincare firm Rhode in a deal valued up to $1 billion. 

While Victory Capital’s bid wasn’t taken forward, all the managers said that the general quality of the M&A deals they’re seeing is strong, although it varies sector by sector.

Can you still get a slice of the AI-American pie?

Taking a stake in small caps doesn’t mean investors have to sacrifice exposure to the AI trend dominating investors’ attention. 

The big US tech firms are putting billions of capex into building out their AI infrastructure and capabilities.

“US smaller companies offer investors access to parts of the economy that large-cap indices often overlook,” including this AI build out says Jon Brachle, co-manager of the JPMorgan US Smaller Companies investment trust.

These names operate in “specialist niches, serve domestic growth markets or supply critical components and services to larger industries” he says that in many ways the AI boom was being built by companies “we rarely hear about”.

“While attention tends to focus on chipmakers or cloud providers, many smaller US companies are quietly supplying the critical infrastructure that allows AI to scale,” and the breadth of opportunity at the low cap end means investors can gain AI exposure though businesses that are earlier in their growth journey.

“It’s therefore not surprising that investors looking to broaden their US exposure and diversify beyond the largest technology names are looking further down the market-cap spectrum,” something they can do at discount to the record high valuations of the Mag 7 and any ‘AI winner’ in the S&P 500 he adds.