A trillion dollars is a lot of money. And thanks to the recent market swoons and gains over the last few years, the number of firms with $1 trillion+ market caps has continued to grow. And with many of these mega-caps driving and being responsible for most of the market’s overall returns, it’s easy to see why investors have continued to plow much of their attention towards these stocks. The year of the mega-cap is certainly upon us for sure.
But maybe we shouldn’t be so quick to focus solely on the mega-caps.
Small-caps need love, too. And, in fact, from a portfolio perspective, they have historically offered better long-term returns than their mega-cap brothers and sisters. When constructing a model portfolio and building an asset allocation model, small-caps just make sense.
The Road to a Trillion
The simple way to think about market cap is a measurement of a firm’s value and size. Multiplying the current market price of a company’s stock by the total number of outstanding shares will provide a firm’s market cap. So, if a firm has 1 million shares outstanding and it’s currently trading for $25 per share, its market cap is $25 million.
To make things easier for indexing firms, investors, analysts and the rest of Wall Street, there are some standards — albeit, loose requirements — for banding similar firms together by market cap. Small-cap stocks are firms with market capitalizations between $250 million and $2 billion; mid-cap stocks have a value between $2 billion and $10 billion; whereas, large-cap stocks have valuations above $10 billion.
But in recent years, we’ve been forced to add another definition to the scale: mega-caps. And the size of some of these firm’s has been staggering.
Back in 2018, Apple broke the mold by becoming the first firm to have a $1 trillion market. The company subsequently broke the record again in 2023, hitting $3 trillion for its market cap. Since that time, Amazon, Nvidia, Google and Microsoft have all eclipsed the milestone. TSMC, Berkshire Hathaway, Eli Lilly and Broadcom are each within spitting distance of the mark.
As these firms have grown, their returns have grown as well. For example, NVIDIA is up 170% year-to-date. And given the sheer size of many of these mega-caps, they’ve had a big pull on the overall market. NIVIDA’s return has contributed roughly 33% of the S&P 500 Index’s year-to-date return.
With the rise of the mega-caps, investors have been drawn further and further into them.
Ignoring Another Opportunity
But in the flock to the mega-caps, investors fled small-cap stocks. Outflows for small-cap funds — both active and passive — have been in the billions. This has affected returns. For the first quarter of 2024, when NVDA’s huge run-up began, the Morningstar US Small Cap Index returned 5.7%. That’s about half of what large-cap stocks returned. Looking further, small-caps managed to return 48% over the last five years, compared to 92% for large-caps.
With that, small-caps now represent just 4% of the broader U.S. stock market. The long-term average is slightly above 8%. This low percentage has only occurred twice before — at the beginning of the Covid-19 pandemic and during the Great Depression.
Clearly, money is moving from smaller firms to larger ones and, increasingly, to the mega-caps.
But investors may want to rethink that stance. Particularly, if they are looking to build a successful model. That’s because small-caps offer plenty of benefits.
For starters, small-caps are better diversified. The main theme of the rise of the mega-caps has been tech. Technology and the potential for A.I., data mining, automation and other trends to change our world. But promise — and potential hype — doesn’t always translate into long-term gains. Valuations for the mega-cap tech giants and the sector overall have gotten stretched very far. However, small-caps offer a broader set of sectors rather than tech-concentration. This chart from Brown Advisory shows the breakdown.
Source: Brown Advisory
That diversification also plays out with regards to economic conditions. Small-caps tend to play by a different set of rules with regards to credit cycles, economic growth and business-cycle trends than their larger siblings do. This provides a different set of gains and expectations during different parts of the cycle.
Smaller companies tend to grow revenues and earnings faster than their larger counterparts as well. Investing in these companies early in their life cycle could therefore provide more upside over the long haul. This shows up in returns. Investing $1 into the small-cap index back in 1925 would be worth around $39 today. Had you done the same for large-caps, it would only be worth around $16 today.
Small-caps also offer an expanded income opportunity. Not all small-caps are high flying, unprofitable start-ups. In fact, the bulk of them are in the other camp. Many small-cap names pay dividends and have continued to increase those dividends for decades.
Adding Small-Caps to a Model Portfolio
While there has been nothing wrong with the recent mega-cap rally, many investors are potentially leaving long-term gains and diversification benefits on the table by ignoring their smaller cousins. Small-caps have long proven themselves to be big winners for a portfolio.
Luckily, getting exposure to small-caps is easy. There are numerous ETFs that can provide broad exposure to the sector for low costs and broad diversification. Active management can play a big role too in expanding on returns and buying so-called quality. Because of their small size, many small-caps are ignored by Wall Street and the news media. This can provide inefficiencies to exploit by active managers.
The question is, just how much exposure? Small-caps feature higher rates of volatility than their larger siblings. So, investors need to gauge their risk tolerances accordingly when considering the sector.
Small-Cap ETFs
These funds were selected based on their year-to-date returns, which range from 5.2% to 8%. They have expenses between 0.05% to 0.26% and assets under management between $7.6B and $145B. Their yields are between 1% and 1.8%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| VB | Vanguard Small-Cap ETF | $145B | 8% | 1.5% | 0.05% | ETF | No |
| IWM | iShares Russell 2000 ETF | $65.5B | 6.5% | 1% | 0.19% | ETF | No |
| DFAS | Dimensional U.S. Small Cap ETF | $7.6B | 6.1% | 1.1% | 0.26% | ETF | Yes |
| AVUV | Avantis U.S. Small-Cap Value ETF | $10.9B | 5.2% | 1.8% | 0.25% | ETF | Yes |
In the end, small-cap stocks offer plenty of growth, return and diversification benefits. And right now, investors seem to be ignoring them in favor of the mega-caps. By overweighting the largest of the large, investors are doing their portfolios a disservice. Adding small-caps makes sense — particularly for those investors following a model portfolio.
Bottom Line
The rise of the mega-caps have put small-caps back on the shelf for many portfolios. However, that’s a real shame for investors. The smallest stocks offer plenty of benefits for a portfolio. For investors looking to build a diversified portfolio, they need small-cap stocks.
