Unlocking Small Cap Outperformance in a Shifting Market Landscape

In the ever-evolving landscape of global equities, small-cap stocks have long been a double-edged sword: offering outsized returns in favorable cycles but suffering disproportionately during downturns. The 2023–2024 period has been no exception. U.S. small-cap equities gained 11% in 2024, yet this paled in comparison to the 24% surge in large-cap stocks, driven by the Magnificent Seven's dominance, according to a Janus Henderson report. Meanwhile, global small-caps traded at a valuation discount to large-caps, with forward P/E ratios significantly below historical averages, as noted in an AXA IM analysis. This divergence raises a critical question: How can investors navigate the inherent risks and inefficiencies of small-cap markets to unlock outperformance? The answer lies in active management's strategic edge.

Market Shifts and the Drivers of Small-Cap Underperformance

The underperformance of small-cap equities in 2023–2024 was not arbitrary. Inflation, elevated interest rates, and recession fears disproportionately hurt smaller firms, which often lack the balance-sheet strength and pricing power of their larger peers, as the Janus Henderson report notes. For instance, higher borrowing costs constrained capital expenditures and R&D budgets for small-cap companies, while retail investors-key buyers of small stocks-retreated to cash or mega-cap tech shares, according to the AXA IM analysis.

However, the tide began to turn in mid-2024. Anticipation of Federal Reserve rate cuts and pro-business policies from the incoming U.S. administration sparked renewed interest in small-caps. Analysts now project 22% earnings-per-share (EPS) growth for small-caps in 2025, outpacing the 15% expected for large-caps, as the Janus Henderson report projects. Structural trends such as reshoring, AI-driven demand for data centers, and electrification further position small-cap firms to benefit from long-term tailwinds, as the Janus Henderson report observes.

The Valuation Discount: A Mispricing Opportunity

The current undervaluation of small-caps is striking. Global small-cap equities trade at a 30% discount to large-caps in terms of price-to-book ratios and a 40% discount in price-to-earnings ratios, as noted in the AXA IM analysis. This gap reflects market overcorrection rather than fundamental weakness. Smaller firms with domestic revenue exposure-such as those in the U.S. and Japan-have become particularly attractive as investors hedge against geopolitical risks, including potential Trump-era tariffs, according to the Janus Henderson report.

Active managers are uniquely positioned to exploit these mispricings. Unlike passive strategies, which mechanically track indices, active approaches can focus on niche sectors and overlooked companies. For example, AXA IM's Equity QI team leverages machine learning and multi-factor strategies (value, momentum, quality) to identify small-cap firms poised to outperform, as the AXA IM analysis explains. This is critical in a market where 70% of small-cap stocks lack regular analyst coverage, as Osterweis research shows, creating fertile ground for skilled managers to uncover hidden value.

Active vs. Passive: A Nuanced Performance Debate

The case for active management in small-cap investing is bolstered by recent performance data. In 2024, 43% of active small-cap strategies outperformed passive benchmarks, a rate that exceeds the 37% success rate for mid- and large-cap active strategies, according to a Morningstar analysis. Over the first half of 2024, only 15% of small-cap active funds underperformed the S&P SmallCap 600, compared to 71% for mid-cap and 57% for large-cap funds, according to an ETF report.

This outperformance is not a fluke. Structural inefficiencies in small-cap markets-such as lower liquidity and less institutional ownership-create persistent opportunities for active managers. Osterweis research underscores that small-cap managers have historically generated more alpha due to their ability to capitalize on rapidly growing companies and undervalued sectors, as Osterweis research shows. While long-term success rates for active small-cap strategies dip to 26% over a decade, as the Morningstar analysis notes, the short-to-medium-term advantages remain compelling, especially in volatile environments.

Strategic Imperatives for Active Managers

To harness the small-cap opportunity, active managers must adopt a multi-pronged approach:
1. Sector Rotation: Prioritize industries aligned with macro trends, such as industrials (reshoring) and materials (electrification).
2. Quantitative Screening: Use algorithms to identify firms with strong balance sheets, improving margins, and low analyst coverage.
3. ESG Integration: Factor in regulatory tailwinds, such as tax incentives for green energy startups.
4. Geographic Diversification: Target small-cap markets in Japan and Europe, where domestic exposure and rate cuts are amplifying returns, as the Janus Henderson report observes.

Conclusion

The small-cap market's recent underperformance has created a rare confluence of undervaluation and structural opportunity. While passive strategies offer broad exposure, active management's ability to navigate inefficiencies and exploit sector-specific trends makes it the superior choice for investors seeking outperformance. As the Fed's policy pivot and global reshoring efforts gain momentum, the time to act is now-before the market reprices small-caps into the mainstream once more.