U.S. small-cap equities delivered strong performance this year. As measured by the Russell 2000 index, small-cap equities have returned 20.1% year-to-date, outperforming the S&P 500 index by 9.6 percentage points. While a prolonged period of outperformance would be needed to recover the underperformance since 2018 (Exhibit 1), the asset class may be at the start of a more favorable cycle. 

The broader macro backdrop is supportive. Rebate-led private consumption and artificial intelligence (AI)-led business investment have helped sustain robust economic activity despite energy headwinds. Increasing expectations of supply chain normalization and the Strait of Hormuz re-opening also favor a risk-on market rotation, extending support to the small-cap segment in addition to a strengthening economy and broadening AI demand. Fundamentals are also encouraging. Consensus estimates are for headline earnings-per-share (EPS) to grow 50.7% in 2026 and 37.9% in 2027 for small-caps, well above the 24.0% and 15.8% expected for large caps, respectively.

While the demanding expectations on small-cap earnings are often criticized given their weaker balance sheet quality, higher sensitivity to interest rates, and lower exposure to technology, underlying factors appear to have taken a more favorable turn, supporting a constructive outlook for small caps.

Earnings pivot from downgrades

Elevated earnings expectations are not new to small-cap equities. Structurally higher potential growth, combined with greater operating and financial leverage, has historically meant that small caps tend to command a higher earnings growth premium relative to large caps over the cycle.

Although markets have often embedded an expectation that year-over-year earnings growth for small caps should exceed that of large caps by roughly 20 to 25 percentage points, it should be cautioned that recent years have proven vulnerable to disappointment. Over the past three calendar years, final EPS outcomes for small caps were revised down by a cumulative 22%, 40%, and 43% from initial estimates, respectively, as analysts’ assumptions were recalibrated to reflect underlying profitability and evolving business conditions. 

Limited analyst coverage across the small-cap universe likely compounds this pattern, as initial estimates are more prone to information gaps and contribute to higher volatility in earnings revisions. More recent revisions have been relatively less downbeat, as the gap between this year’s EPS growth and last year’s has widened. Revisions for 2027 are more optimistic and are being revised higher, signaling a potential pivot in confidence in small-caps’ earnings prospects (Exhibit 2).

Quality dilution over deterioration

Quality is often cited as a persistent challenge for small caps, as the proportion of loss-making companies in the Russell 2000 Index has risen from 23% pre-2008 to 43% in the latest 1Q26 earnings season. This is likely more of a reflection of market structure rather than a fundamental deterioration of aggregate quality in small-cap indices.

Since the Global Financial Crisis, an increasing tilt towards prospects over profits in small-cap initial public offerings (IPOs), alongside a longer holding period by private equity funds has led to a lower supply of quality companies in the public market. These shifts in market structure have diluted the small-cap universe with less desirable names and reduced the small-cap premium at the index level. On a like-for-like basis, the quality picture appears more resilient. Among companies with comparable earnings data today and 10 years ago, 65% have shown improvement in earnings, which suggests quality dilution at the index level, instead of quality deterioration for small-cap equities.

Moreover, these loss-making names are mostly concentrated in the healthcare sector, which accounts for over one-third of those in the Russell 2000 Index, while other sectors have relatively more manageable levels given more stable profits and resilient balance sheets.

As such, while aggregate quality may appear less favorable on the index, nuances in composition mask the underlying strength of the small-cap universe, where fundamentals are more promising for stronger performance.

Debt a double-edge dynamic

Interest rate sensitivity is another important distinction between small- and large-cap equities, stemming from two key differences: lower interest coverage (1.5x for small-cap vs 8.9x for large-cap) and a greater share of floating-rate debt (41.5% for small-cap vs 18.0% for large-cap). With a thinner margin for buffering financing costs and a larger share of liabilities repricing with market rates, small-caps are mechanically more sensitive to changes in interest rates. This sensitivity to interest rate changes is even more pronounced when policy rates are elevated and financial conditions are tighter, with small-cap performance historically showing a deeper negative correlation to changes in interest rates during these periods (Exhibit 3). 

The fall in rates from the 2023 peak has helped ease some of the pressure on small caps, with correlation also reverting to more neutral territory. That said, interest rate volatility is unlikely to abate in the near term, as uncertainty stems from geopolitical tensions and their inflationary spillovers, renewed labor market strength, and even changes in the U.S. Federal Reserve’s policy communication style under a Warsh-led Federal Open Market Committee.

Small cap equities’ higher sensitivity to rates is increasingly becoming to a double-edged sword, whereby the incremental tailwind or headwind will firmly depend on ongoing geopolitics and economic developments.

From technology to data center demand

Beyond quality and rates considerations, sector composition is also often noted as another structural constraint, as small-cap indices carry meaningfully lower weight in technology than large-cap indices (Russell 2000: 18.5%, S&P 500: 38.6%), especially as markets are increasingly shaped by the structural AI cycle.

That said, market strength is beginning to broaden from AI hyperscalers and hardware manufacturers to industries that contribute to the surge in data center buildouts, with industrials standing to benefit. While exposure to this opportunity set may be shared with private markets nowadays, small-cap equities are still positioned to gain from an extension of this AI demand, given the higher weight in industrials (Russell 2000: 19.4%, S&P 500: 8.3%).

Investment implications

Following years of underperformance, valuations on U.S. small caps continue to screen attractive, as measured by forward price-to-earnings (P/E) ratios relative to large caps, especially for investors looking to extend their equity exposure in a constructive market environment.

On a holistic view, investors may be mindful of historical patterns of earnings disappointment, a decline in aggregate quality in small-cap indices, and lower exposure to technology. However, earnings revisions are beginning to strengthen, while index dilution likely exacerbated the quality decline, and the structural AI tailwind is starting to broaden toward industrials, which small caps bears a higher weight, helping to abate these concerns. The greater sensitivity to interest rates will need careful monitoring given shifting expectations for central banks this year, although stabilizing geopolitical tensions may be an additional tailwind.

More importantly, these points reinforce the importance of selectivity. Return dispersion within small caps (+180% at 95-percentile versus -40% at 5-percentile in the past year) remains substantially wider than in large caps (+127% vs -39%). An actively managed strategy with a fundamentally driven process and a robust risk management framework thus becomes even more meaningful for this asset class in unlocking potential alpha.

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