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Once upon a time, investment managers used to tell a story about the small cap effect. This is where smaller firms had the potential to outperform larger companies, because smaller companies are nippier and able to grow faster. So, if you invested in them, over time you would reap a higher return.

There was much ink spilled showing that this effect persisted over time: if you were prepared to ride out the higher volatility of smaller companies, your returns would be greater.

It’s a good argument, but the world has turned rather differently over the past decade and more, especially in the US equity market, where large caps have consistently outperformed their small-cap peers. This is the case both at the index level, such as the large cap Russell 1000 versus small-cap Russell 2000, and with fund sectors, where the large cap-focused IA North America sector has delivered 73.43% over five years to the end of June, while its more diminutive sibling, North American Smaller Companies, has returned 44.03%. The last full year that the Russell 2000 beat the Russell 1000 was 2016: the date of Brexit and the death of Ronnie Corbett.

What’s happened to the “small-cap effect”, where the greater innovation, risk, and growth potential of small caps is supposed to deliver excess returns?

One argument touted to explain the persistent outperformance of US large caps is that this is where innovation is now. All the excitement around AI development, for example, is with mega caps such as Microsoft or Google. Likewise, quantum computing. Unlike when Bill Gates started, you can’t build one of these in the garage with a soldering iron and a “can-do” attitude. Where innovative start-ups do look promising, they are scooped up by the mega-caps like an amoeba ingesting a bacterium before they get anywhere near the stage of public listing, so there isn’t the uplift to small cap indices that you would expect to see with the acquisition of one of their listed members.

This may well be a contributing factor, though it surely cannot be the whole story. Whatever the case, the small cap effect has not delivered.

US small caps have also been hit by jitters around the impact of US politics on its equity markets, which may seem a little unfair, as analysts’ focus has very much been on the risks entailed in the high valuations of US mega-caps. Although flows to the sector had been strong over one, three, and five years to the end of June, over six months UK investors have pulled £3.68bn from these funds, although North America flows have so far held up.

But any investment case that rests solely on following the herd is likely a weak case. US small caps bring diversification benefits and are attractively valued relative to those mega-caps.

In a world where passive investment is winning an ever-greater share of the pie, small cap equities remains an essentially active space. There is, however, one passive fund in the table below: the SPDR MSCI USA Small Cap Value Weighted UCITS ETF—which is, incidentally, the only value-styled fund to make it onto the table. It’s also one of the few funds in the sector to have the highest Lipper Consistent Return score (5), relative to its Lipper peer group, Equity US Small & Mid Cap. However, you’ll see from the table that it scores a 1—the lowest—for capital preservation. This is calculated on a wider universe than the Lipper classification itself, allowing investors to compare risk across different types of funds, for instance, across the cap scale or geography. No fund on the table below scores higher than a 2, indicating the relative risk of US small caps in general. However, the Consistent Return score of 5 by four of the funds in our table indicate they have delivered a good risk-return trade off over the past five years, relative to their peer group.

Three-year returns range from 53.75% to 0.58%—so, as ever, fund selection clearly matters, and this, again, is reflected in the spread of Consistent Return scores in the table—though, be aware, these are historical scores. If market history simply repeated itself, we’d all be rich.

Table 1: Top-Performing IA North American Smaller Companies Sector Funds Over Three Years (with a minimum five-year history)

(Click on image to enlarge)

All data as of June 30, 2025; Calculations in GBP

Source: LSEG Lipper

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