SUMMARY
Equities in small companies historically have produced greater returns than those of big companies in the wake of recessions. But this outperformance has come at the cost of higher risks.
KEY TAKEAWAYS
U.S. and European small- and mid-cap equities have beaten their large-cap counterparts over time
Higher returns are likely a reflection of the greater risks involved, such as illiquidity and deep selloffs in stress periods
Early-stage bull markets and recoveries from recessions have often favored small-cap equities
Rather than timing the markets, investors might consider a long-term allocation to this sub-asset class
Good things can come in small packages. Think dainty jewelry, tiny-but-powerful digital devices or nouvelle cuisine. But the “small-is-beautiful” adage also has relevance when it comes to the stock market.
Over time, shares in smaller companies – aka “small-cap” equities – have tended to deliver high returns as compared to those in large companies or “large-caps.”
To illustrate, check out figure 1. Going all the way back to 1926, U.S. small-cap equities have outperformed their larger counterparts. What’s more, the margin isn’t small.
FIGURE 1. U.S. SMALL-CAPS’ AND LARGE-CAPS’ LONG-TERM RELATIVE PERFORMANCE
Chart shows the historical cumulative excess performance of U.S. small-cap versus U.S. large-cap equities. Source: Citi Wealth Investment Lab, Fama and French, using monthly data from July 1926 to December 2024. Time series is Fama and French ‘3 Factor SMB’ Series. See Glossary for definitions.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
What are small-caps? (And mid-caps and large-caps?)
Before we delve into small-caps’ record – and the reasons behind it – let’s nail down some definitions.
An equity’s size is measured in terms of the issuing company’s market capitalization: share price multiplied by the number of outstanding shares. This means a company with a current share price of $5 and 100 million shares outstanding would have a market capitalization of $500 million.
So, how to work out which companies are small- and large-cap? (And indeed, mid-cap!) The usual method is to judge each company compared to the rest of its home stock market. Equity index providers typically do this job for us. In the case of the U.S., S&P categorizes shares like this:
S&P 500 Index: the largest 500 U.S. companies with a market cap above $20.5bn.
S&P MidCap 400: the next 400 companies by size, with a market cap between $7.4bn and $20.5bn.
S&P SmallCap 600: the next 600 companies by size, with a market cap between $1.1bn and $7.4bn.
(Levels as of January 2025)
Over time, as a company changes size, it may shift from one size index to another.
For example, take a young company whose profits and share price are increasing rapidly. Having gone public, it could rise from the small-cap index up through the mid-cap index and eventually join the large-caps.
Likewise, a company whose share price falls significantly could find itself reversing that journey.
Other companies can spend long periods in a single size index or move between two such indices from time to time according to their share price movements.
| U.S. Small-Cap | U.S. Large-Cap | Europe Small-Cap | Europe Large-Cap | |
|---|---|---|---|---|
| Ann. Return | 9.5% | 8.5% | 8.0% | 4.5% |
| Ann. Volatility | 19.6% | 15.2% | 18.3% | 14.9% |
| Sharpe Ratio | 0.48 | 0.50 | 0.43 | 0.26 |
| Max Drawdown | -52.2% | -50.9% | -62.2% | -52.4% |
Source: Citi Wealth Investment Lab, Bloomberg. Monthly data from Dec 2000 to January 2025. U.S. Small-Cap is the S&P SmallCap 600 Gross Total Return USD Index; U.S. Large-Cap is the S&P 500 Gross Total Return USD Index; Europe Small-Cap is the MSCI Europe Small Cap Gross Total Return EUR Index; Europe Large-Cap is the MSCI Europe Large Cap Gross Total Return USD Index converted into EUR. See Glossary for definitions.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. Past performance is no guarantee of future results. Real results may vary.
But why might small-caps have performed this way?
In the stock market, there’s no such thing as a free lunch, of course, be it nouvelle cuisine or anything else.
Higher returns may represent compensation to investors for taking outsized risks.
Another look at figure 2 shows that small-caps’ outperformance has been served up with a side order of additional risk.
One way to measure risk is to observe “maximum drawdown” – the largest peak-to-trough decline that an asset’s price experiences in a certain period.
Between 2001 and 2023, both U.S. and European small-caps suffered bigger maximum drawdowns than their larger counterparts.
In the case of Europe, the gulf was wider: a 62.2% peak-to-trough plunge versus a 52.4% decline for large-caps.
In both geographies, small-caps were also more volatile, as measured by their standard deviation.
There are a variety of reasons for this additional riskiness.
Smaller companies may have less tested business models; be less established in their industries; have a more concentrated offering and operate in a smaller geography; have less access to funding; have less liquid shares; and offer less transparency around their fundamentals.
There are other risk measures to consider, and investors should obtain advice based on their own individual circumstances from their own tax, financial, legal and other advisors about the risks and merits of any transaction before making an investment decision, and only make such decisions on the basis of their own objectives, experience, risk profile and resources.
When have small-caps done better and worse?
As we’ve seen, small-caps have performed better than large-caps over the long term.
That said, the outperformance has not occurred consistently. Rather, it has come in bursts.
These periods have sometimes lasted a decade or even more, such as between 1999 and 2011 in the U.S. .
The flipside of this is that small-caps have also had prolonged periods of underperformance.
Between 1983 and 1999, for example, the general trend was for large-cap dominance, albeit with a decent surge for small-caps in the early 1990s.
However, the relationship isn’t entirely random.
FIGURE 3. U.S. SMALL-CAPS HAVE FLOURISHED IN THE FIRST YEARS OF BULL MARKETS
Source: Citi Wealth Investment Lab using FactSet financial data and analytics from 31 October 2002 to 31 January 2025. U.S. Small-Cap is the S&P SmallCap 600 Gross Total Return USD Index; U.S. Large-Cap is the S&P 500 Gross Total Return USD Index. See Glossary for definitions.
Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Index returns do not include any expenses, fees or sales charges, which would lower performance. For illustrative purposes only. Past performance is no guarantee of future results. Real results may vary.
Over time, there’s been a marked tendency for small-caps to beat large-caps coming out of recessions.
In the U.S., small-caps have outperformed large-caps in the year after fourteen of the sixteen recessions since 1926.
In Europe, small-caps have outperformed large-caps in the year after three of the four Euro area recessions since 2001.
In both cases, a faster recovery in corporate earnings appears to have been a driver.
Of course, there is no certainty that such results will recur after future recessionary periods.
Considering small-cap stocks in a diversified portfolio
Observing small-caps’ long-term performance historically, some investors may wonder if it might be better to build an entire equity allocation from small-caps in pursuit of returns.
Others might be tempted to switch aggressively between large- and small-caps in an attempt to catch those bursts of performance over time that we noted.
However, we would not suggest adopting either of these approaches.
An entire long-term equity allocation from small-caps would be risky and prone to sustained periods of underperformance – perhaps lasting years at a time.
Trying to shift an equity allocation from one to the other in the hope of mainly being in the stronger performing would be fraught with complications, being a form of market timing.
Instead, suitable investors could consider long-term portfolio exposure to both small-caps and large-caps.
That said, certain periods may merit bulking up or trimming down small- and mid-cap holdings depending upon investor objectives.
