Are small-cap stocks coming back into style?

Wall Street is known for finance, not fashion, but any responsible investor needs to be mindful of the current trends.

Like a well-tailored suit, some popular investments are worth paying a premium for, and others that seem attractive will end up like the faux brick walls in Bud Fox’s apartment: a regrettable decision that’s hard to forget. Our job is to know the difference.

Small-cap stocks have been out of favor for years thanks to their relative underperformance and interest rates that have remained “higher for longer.” But small-caps have bounced big time in July with a growing consensus that rate cuts from the Federal Reserve are coming in September.

As a quick refresher, smaller companies are generally more reliant on borrowing money to finance their growth (unlike corporate behemoths with billions in cash). Higher interest rates mean more expensive loans and smaller profit margins. That’s the simple argument as to why small-caps have lagged large-caps in recent years but surged this month.

Through the past 10 calendar years, the Russell 2000 has averaged annual returns of 8.2% compared with 13% per year for the S&P 500. In six of the past seven years, the S&P 500 has been the better performer. Interest rates, you might recall, were exceptionally low for the majority of those years, so monetary policy does not offer a full explanation.

The truth is small-cap benchmarks have other factors working against them. For one, the Russell 2000 contains a lot more money-losing companies. Heading into 2024, only 60% of the companies in the Russell 2000 reported positive earnings-per-share. Many of those will eventually reach profitability, but some will not, and there is added downside risk in the meantime. By comparison, 93% of S&P 500 companies were profitable at the start of this year.

At the other end of the spectrum, the best performers in the Russell 2000 eventually “graduate” to a larger-cap index. Super Micro Computer, a California server and data storage company, grew so much it advanced to the S&P 500 in March. The stock has outperformed Nvidia year-to-date, but most investors who own a small-cap index fund will end up selling it whether they want to or not.

Another trend working against small-caps is more and more of the best start-ups are choosing to remain private companies altogether. The rise of hedge funds and venture capital firms has created billions of dollars looking for an investment home, which means public stock exchanges and individual investors end up with a shrinking share of the fastest-growing companies in need of capital.

OpenAI and its CEO Sam Altman, the poster child of the Artificial Intelligence revolution, received a $10 billion pledge from Microsoft and significant investments from other venture-capital firms in the past 12 months rather than going public. Stripe, which sells payments software for e-commerce businesses, raised $700 million as a private company in February rather than doing a more traditional IPO.

There’s no denying small-cap stocks are overdue for a period of outperformance. Year-to-date through June 30, the S&P 500 had outperformed the Russell 2000 by the largest margin in 25 years. Less restrictive monetary policy from the Federal Reserve could be the spark this asset class so desperately needs. But longer term, it still looks like an uphill battle for small-cap benchmarks.

Considering actively managed strategies or an index that curates its holdings using criteria more nuanced than market capitalization alone would better serve investors interested in rotating dollars toward small-caps. For those who prefer avoiding small-caps entirely, another option to play a broadening market rally is to utilize equal-weighted strategies with smaller weightings to the biggest technology stocks.

Whatever style box you invest in, be sure to understand the substance of what you’re buying.

Ben Marks is chief investment officer at Marks Group Wealth Management in Minnetonka. He can be reached at ben.marks@marksgroup.com. Brett Angel is a senior wealth adviser at the firm.