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U.S. small caps: Ready for a comeback?
16/01/2026
Have small caps seen a weak decade, or were large caps simply off the charts?
When evaluating listed equities, one question often shapes portfolio decisions: Does size matter? A look at history suggests that it does. Smaller companies, while offering growth potential, typically operate with less financial resilience than their larger peers, making them on average more vulnerable to financial shocks such as higher interest rates. This is why investors usually require a risk premium, the well-known ‘size premium,’ a concept formalized in Fama and French’s landmark 1993 paper on asset pricing.[1]
Since the 1990s, small-capitalization companies (‘small caps’) delivered impressive returns compared to their larger counterparts, a trend that persisted well into the mid-2010s.[2] Over the past decade, however, the picture has shifted somewhat: small caps have generally underperformed their large-cap peers, as shown in our Chart of the Week. What explains this divergence? Below, we highlight factors that contributed to the recent outperformance of large caps as well as arguments why small caps might be well positioned for the years ahead.
First, a topic that is universal these days: artificial intelligence. With technology driving a significant share of equity returns, sector composition has been a critical differentiator. In the S&P 600, technology stocks represent only about 14% of the index, compared with roughly 34% in the S&P 500. This limited exposure has left small caps on the sidelines of the AI-driven rally that propelled large caps higher. For perspective, the Magnificent 7[3] have returned a staggering 38% p.a. over the past decade compared to 9% p.a. for small caps, proxied by the S&P 600. In other words, the recent performance gap reflects less weak performance in small caps but more the sheer, unmatchable run in large-cap tech.
Second, private market dynamics have reshaped the small-cap landscape. Robust M&A activity and the growing appeal of private funding have partially reduced the pipeline of innovative firms entering public small-cap indices. As a result, the dynamism traditionally associated with small caps has been blurred, and the IPO route has become less attractive. A notable trend has been the aggressive acquisition strategies of large corporations, which often buy promising companies before they reach public markets.
Despite these headwinds, we believe the outlook for U.S. small caps could turn more constructive, driven by two critical factors, valuations and funding costs. Small caps currently trade at a price-to-earnings ratio discount of around 20% below that of large caps – a historically rare discount that has often preceded periods of relative outperformance. The last time we have seen such a valuation gap was in the early 2000s which was followed by a decade of strong returns.
Another piece in the puzzle is the interest rate sensitivity: small caps typically rely more on debt financing than on public equity markets, making them responsive to changes in funding costs. If interest rates were to decline further, as we forecast for the U.S. for the coming year, these companies could benefit from significant tailwinds.
Finally, when looking at historic performance, quality and valuation factors rebounded specifically after the Russell 2000 had underperformed the S&P 600 by 10% or more, as recently happened. However, selection remains critical. As Michael Sesser, Senior Equity Portfolio Manager, puts it: "In my opinion, fundamentals are about to matter again in U.S. small caps."
Lagging small cap returns or simply exceptional large cap returns?
*Total return indices
Sources: Bloomberg Finance L.P.; DWS Investment GmbH as of 12/18/25
This information is subject to change at any time, based upon economic, market and other considerations and should not be construed as a recommendation. Past performance is not indicative of future returns. Forecasts are based on assumptions, estimates, opinions and hypothetical models that may prove to be incorrect. Alternative investments may be speculative and involve significant risks including illiquidity, heightened potential for loss and lack of transparency. Alternatives are not suitable for all clients.