While academics debate the validity of the “small cap effect” (i.e. small caps are less efficient/ riskier, thus requiring a higher level of return to attract investors), the practical answer is simple: if the small cap effect existed, it has now seemingly vanished – at least in the U.S. The Russell 1000 outperformed the Russell 2000 counterpart by more than 1000 and 800 basis points for the one- and three-year periods respectively ending March 31, 2025. The discrepancy was exacerbated by the election, as the small-cap benchmark fell 22% (technically bear market territory) from its postelection high on Nov. 25, 2024 through April 4, 2025.
But that weakness may be transient. The U.S. small-cap index has historically rebounded with average gains of 6.8% over the three months after entering a bear market, and nearly 12% over the following six months, according to Dow Jones Market Data. So don’t write off U.S. small caps just yet … history, valuation and macro conditions suggest a comeback in 2025.
Why such a big dislocation between large and small caps?
For value investors like us, small caps offer the perfect trifecta: 1) diversification and cyclical industry exposure in marked contrast to the tech-heavy large cap concentration, 2) attractive valuations, looking heavily discounted compared to larger peers on both an absolute and relative basis and 3) a fertile hunting ground in an inefficient investment universe that may be bound for a resurgence in 2025.
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