In portfolio management offices, a discussion is taking place that seldom appears on the front page. It has nothing to do with the Fed’s upcoming meeting, Nvidia’s most recent earnings, or which megacap will reach $4 trillion first. Because it touches on one of the most dependable long-term assumptions in investing—that small businesses eventually outperform large ones given enough time and patience—it is quieter and, in some ways, more unsettling.
It appears that this assumption is becoming more and more tenuous. Since its peak in 2021, the Russell 2000, which most investors use as a shorthand for the small-cap universe, has been a constant source of annoyance. Since 2003, the quality difference between small-cap and large-cap stocks has been growing. By standard deviation of returns, the small-cap index has been almost 30% more volatile than the large-cap index since 1991, and following significant market events, its average drawdown has been 3.7 percentage points deeper. To be precise, none of those figures are new. However, that’s the direction they’re going.
| Benchmark index | Russell 2000® Index — primary benchmark for U.S. small-cap stocks; peaked in 2021 |
|---|---|
| Underperformance trend | Small caps have badly trailed large caps since 2021; quality gap vs. large caps widening since 2003 |
| Volatility gap | Small-cap index 29.7% more volatile than large-cap index (measured by standard deviation, since 1991) |
| Drawdown gap | Average drawdown of small-cap index was 3.7 percentage points deeper than large-cap since 1991 |
| Profit margin gap | Small-cap margins have trailed large-cap margins for nearly 40 years (Furey Research / FactSet, to June 2025) |
| Private market effect | High-growth companies staying private longer; cash-rich private firms competing with public small-caps for business |
| IPO cycle parallel | Google went public 2004 (~2 yrs post-bear bottom); Facebook in 2012 (~4 yrs post-2008 bottom) |
| Key structural risk | Public companies increasingly being taken private at premium prices, shrinking the investable small-cap universe |
| Analyst outlook | Some forecast accelerated earnings growth for small caps in 2026; recent Fed cuts cited as supportive |
| Reference source | Morningstar — Why Are Small-Cap Stocks Underperforming? |
The explanation that is most frequently discussed isn’t the most intriguing one. Although rising rates have actually hurt smaller businesses with more floating-rate debt, it’s not interest rates. Although small-cap profit margins have lagged behind those of larger companies for almost 40 years—a disparity that is visually striking according to Furey Research data through mid-2025—it’s not quality. What private markets have done to the publicly investable small-cap universe over the past ten years is the more structural explanation, and it is better to take your time comprehending the mechanism than to ignore it.
The reasoning goes like this: growing, ambitious, and sometimes capital-hungry businesses that would have gone public at the small-cap stage are increasingly remaining private for much longer. These days, venture capital and private equity provide those businesses with access to massive capital pools without the shareholder scrutiny, quarterly earnings pressure, or disclosure requirements associated with a public listing. When a $4 billion private funding round is available, why go public at a $2 billion valuation? The calculus has changed dramatically from the standpoint of the founder. Additionally, the most promising growth companies are no longer as prevalent in public small-cap indexes as they once were.
Even though this pattern seems novel, it’s important to keep in mind that it has historical precedent. Investment experts frequently cited Google as the outstanding private company that declined to go public in the years following the dot-com bust. About two years after the 2002 bear market low, it finally went public in 2004. Facebook, which went public in 2012—four years after the market reached its floor—was the subject of a similar discussion following the 2008 financial crisis. When circumstances warranted it, both businesses went public and went on to transform their respective sectors. According to the pattern, businesses don’t remain private indefinitely. They maintain their privacy until they are no longer required to do so.
Watching this unfold gives the impression that the private market expansion is affecting the small-cap industry in two ways at once. In addition to depleting the pool of qualified applicants, it also puts wealthy private companies in direct competition with already-existing public small-caps for clients, contracts, and talent—a point that is less frequently discussed. A well-funded private competitor that doesn’t have to turn a profit this quarter is in a difficult position to compete with a publicly traded regional software company for enterprise clients. No single earnings report can accurately reflect the ways in which the playing field has changed.
Here, the IBM example is worth considering. By almost every metric, IBM was among the best businesses in the world in 1970. It dominated the computing industry, produced large profits, and was worth about $45 billion. In fact, its share price had dropped twenty-three years later. It turns out that stock performance is not always correlated with quality. The same reasoning holds true for small caps as well: just because they are of lower quality than large caps doesn’t mean they will always perform poorly. The analysts at Lord Abbett carefully pointed out that correlation does not equate to causation.
Whether the current period of poor performance is a structural break or just an extended cycle low is still up for debate. According to some research conducted in 2026, small caps’ earnings growth was accelerating, and the recent rate cuts by the Federal Reserve eliminated at least one of the challenges facing smaller, more leveraged businesses. In the same way that Google and Facebook did for their respective eras, it’s possible that the next big IPO wave, which historical cycles indicate will eventually occur, replenishes the public small-cap universe with a new cohort of quality entrants. Alternatively, the math may have been permanently changed by private markets.
Observing all of this from a distance gives the impression that the small-cap story isn’t finished, but that the current chapter is more difficult to read than any in recent memory.