Investors can be forgiven for seeing little point in investing in U.S. stocks too small to make the large-cap cut.
After all, over the past 10 years, large-cap stocks, as represented by the benchmark S&P 500 Index, have generated returns that handily outpaced those of small- and mid-cap stocks as measured by the Russell 2000 and S&P MidCap 400 Indexes, respectively. The 10-year trailing total return for the S&P 500 was 288.7%, whereas those of the S&P MidCap 400 and the Russell 2000 were 213.9% and 182.6%, respectively. All trailing returns are calculated as of March 23, 2022.
Over the Long Term, Large-Caps Look Less Impressive
Large-cap stocks have also outperformed their smaller cousins if you look at the past one-, three-, five-, and even 15-year periods. If large companies are both less risky and yet are also capable of outperforming over such a lengthy time frame, why consider anything else?
The answer is that over a longer time frame, the picture changes dramatically. Looking over a 20-year trailing period, for example, the S&P MidCap 400 outperformed both large and small-cap stocks. And mid-cap outperformance is even more pronounced over 25- and 30-year periods. For example, in the past 25 years, the S&P MidCap 400 has delivered a cumulative return of 1,350%, sharply outpacing the S&P 500’s 805% and the Russell 2000’s 710%.
A Winner-Take-All Market Favors Large-Caps
So what happened to change the investment picture?
According to the several market strategists contacted by Investopedia, the reasons for this change in market-cap leadership are many, ranging from a slowdown in economic growth over the past decade that has given a relative advantage to larger-cap stocks to the rise of the so-called winner-take-all, market that provides outsized advantages to a small collection of household-name companies that lead their industries.
It also hasn’t hurt matters that far more retirement dollars every day automatically flow into large-cap exchange-traded funds (ETFs) and index mutual funds than into small- and mid-cap funds. This provides an added boost to shares of the large companies that make up the components of these indexes. For example, over the past five years, the Vanguard S&P 500 ETF (VOO) has received more than $128 billion in flows whereas the Vanguard Mid-Cap ETF (VO) has received only $17 billion in flows during the same period.
“Research has shown that the largest companies account for substantially more of the market capitalization than they did 50 years ago, and Washington has had a hand in this,’’ says Jack Ablin, a founding partner and chief investment officer at Cresset Capital, a wealth-management firm. “The way the game is set up, we want our largest companies to succeed because they play in an a larger competitive arena against foreign companies.”
And trends such as outsourcing to lower-labor-cost countries and deregulation have allowed these corporate behemoths to increase their profit margins and “reign supreme,” he adds.
Though these trends provide a strong tailwind for large-cap stocks, that’s not to say that economic and market forces can’t conspire to allow small- and mid-cap forces to outperform large-cap stocks. When stocks gained dramatically in the spring of 2020 in the wake of the bear market caused by the sudden outbreak of the COVID-19 pandemic, it was small-cap stocks that led the way. Over a one-year period ending March 23, 2021, the Russell 2000 was up a remarkable 120%, leading the S&P MidCap’s 110.9% and the S&P 500’s 77.8%.
"Just as large-cap companies tend to outperform during periods of slow economic growth because of their greater ability to cut costs, small- and mid-cap companies tend to outperform when the economy is growing stronger, as was often the case in the 1990s and other period of the post-World War II years," says Jim Paulsen, the chief investment strategist at Leuthold Group, a money management and market-research firm.
“Smaller-cap companies have higher operating leverage to the economy and accelerated growth benefits the small over the large,’’ says Paulsen.
Paulsen says he thinks small- and mid-cap stocks have the potential to outperform large-cap stocks in the coming years because he believes that real economic growth will be stronger than it’s been for much of the past decade. “I would be overweight small- and mid-cap stocks relative to benchmark weightings,” he adds.
And David Kotok, the chairman and chief investment officer of Cumberland Advisors, believes that there should always be a place for mid-cap and small-cap stocks in a properly diversified portfolio.
“In the current world, this allocation [based on market cap size] needs to be a continuum of change,” he says. “Old rules of [set] percentages now fail often. I think the best answer for investors is to be in sectors and industries with growth trajectories and in companies with solid balance sheets and positive earnings. There is nothing wrong with mid-cap or small-cap companies with those characteristics.”
The Bottom Line:
Over the past 20- and 30-year periods, U.S. mid-cap stocks have outperformed the better-known large-cap sector. But over the past 15 years, large-cap stocks have taken the lead for a host of reasons that aren't short lived.