Unlocking Small-Cap Potential: A Tactical Allocation Strategy in a Mega-Cap Market

In 2025, the U.S. equity market is witnessing a pivotal shift as small-cap stocks begin to reclaim ground after a 14-year period of underperformance relative to mega-cap dominance [1]. This prolonged cycle—historically averaging 11 years—has created a valuation dislocation that now favors small-cap equities, particularly in sectors like industrials and financials. With forward P/E ratios for the S&P 600 at 15.8 versus 22.48 for the S&P 500 and 28 for the Magnificent Seven, the gap is the widest in 25 years [2]. Analysts project small-cap earnings growth of 22% in 2025, outpacing large-cap peers by 7 percentage points, driven by broadening economic expansion and favorable macroeconomic tailwinds [3].

Sector Rotation and Structural Tailwinds

The underperformance of small-cap industrials and financials over the past decade has created a compelling entry point. For instance, the Avantis U.S. Small Cap Value ETF (AVUV), which allocates 27% to financials and 19% to industrials, has demonstrated resilience in these sectors. Despite a 2025 YTD return of +3.57% [4], AVUV’s 5-year annualized return of 19.28% underscores its long-term value proposition [5]. Similarly, the Invesco S&P SmallCap 600 Pure Value ETF (RZV) has a 13.01% allocation to financial services and 8.72% to industrials, with a P/B ratio of 0.78 as of June 30, 2025—well below the ETF category average of 1.22 [6].

Global small-cap opportunities are equally compelling. The iShares MSCI International Small-Cap Multifactor ETF (ISCF) has a 21.03% allocation to industrials and a P/E ratio of 14.15 as of August 2025 [7]. Its focus on value, quality, and momentum factors aligns with the broader trend of undervalued small-cap sectors benefiting from deglobalization and reshoring efforts [8].

Tactical Allocation: Balancing Risk and Reward

While small-cap ETFs offer attractive valuations, investors must adopt a selective approach. AVUV’s 0.25% expense ratio and focus on low-valuation, high-profitability stocks make it a cost-effective option for domestic small-cap exposure [9]. RZV’s 0.35% expense ratio is slightly higher but justified by its pure value tilt and sector diversification [10]. For international exposure, ISCF’s 0.45% expense ratio is offset by its 26.8% 2025 YTD return, driven by global industrial and financial sector outperformance [11].

However, risks persist. Small-cap ETFs like AVUV and RZV are sensitive to interest rate volatility and economic downturns. For example, AVUV’s -3.35% YTD return in early 2025 highlights the sector’s cyclical nature [12]. Investors should pair these ETFs with defensive holdings or hedge against macroeconomic shocks.

Conclusion: A Case for Rebalancing

The confluence of attractive valuations, favorable market cycles, and sector-specific tailwinds positions small-cap ETFs as a cornerstone of 2025 portfolios. As the market transitions from a mega-cap dominated era to a more balanced growth trajectory, tactical allocations to AVUV, RZV, and ISCF can capitalize on undervalued sectors while mitigating risks through diversification. With rate cuts and reshoring initiatives on the horizon, the time to act is now.

Source:
[1] Large vs Small Cap Stocks Show Surprising Shift in 2025 [https://www.stonex.com/en/thought-leadership/08-26-2025-large-vs-small-cap-stocks-show-surprising-shift-in-2025/]
[2] Uncovering Value in Small-Cap and Undervalued Stocks [https://markets.financialcontent.com/wral/article/marketminute-2025-8-26-beyond-the-giants-uncovering-value-in-small-cap-and-undervalued-stocks]
[3] What Trends Are Guiding Global Small-Caps in 2025? [https://www.americancentury.com/institutional-investors/insights/global-small-caps-2025-trends/]
[4] AVUV: Total Return Chart (with Dividends Reinvested) [https://totalrealreturns.com/n/AVUV]
[5] AVUV - Avantis® U.S. Small Cap Value ETF [https://www.avantisinvestors.com/avantis-investments/avantis-us-small-cap-value-etf/]
[6] RZV Invesco S&P SmallCap 600® Pure Value ETF [https://etfdb.com/etf/RZV/]
[7] iShares International Small-Cap Equity Factor ETF | ISCF [https://www.ishares.com/us/products/272823/ishares-msci-international-small-cap-multi-factor-etf]
[8] Outlook for small caps in 2025 [https://gabelli.com/research/small-cap-outlook-2025/]
[9] Best small-cap ETFs in September 2025 [https://finance.yahoo.com/news/best-small-cap-etfs-february-051259381.html]
[10] Invesco S&P SmallCap 600® Pure Value ETF [https://www.invesco.com/us/financial-products/etfs/product-detail?audienceType=investor&ticker=rzv]
[11] 7 Best Small-Cap ETFs to Buy for Growth [https://money.usnews.com/investing/articles/small-cap-etfs-to-buy]
[12] AVUV - Avantis® U.S. Small Cap Value ETF [https://www.avantisinvestors.com/avantis-investments/avantis-us-small-cap-value-etf/]