Small Caps: A Statistical Improbability

Let’s talk about small-cap stocks. Not because they’re inherently interesting – most financial instruments aren’t, really – but because they’ve been, statistically speaking, rather poorly behaved lately. The Russell 2000, that collection of companies just large enough to be considered (and often just small enough to be forgotten), has only managed to beat the S&P 500 once since 2017. Once. That’s less than a statistically significant sample size, frankly. It was 2020, and the outperformance was a mere 1.5 percentage points. A rounding error in the grand scheme of cosmic finance. (It’s worth noting that the universe itself probably doesn’t care about percentage points, being preoccupied with, you know, everything.)

Now, one might be tempted to continue ignoring them. But that would be… predictable. And predictability, as any seasoned activist investor will tell you, is the enemy of opportunity. We’re entering a phase where the relentless dominance of mega-cap growth stocks – the usual suspects, the tech behemoths – is starting to feel… unsustainable. The last three years have been a bit like watching a single, very large penguin win every race at the Antarctic Olympics. Impressive, certainly, but not terribly exciting. And, more importantly, not likely to continue indefinitely. The AI boom, while undoubtedly fascinating (to those who enjoy increasingly sophisticated algorithms), isn’t a perpetual motion machine. History, that grumpy old historian, suggests as much.

Five consecutive years of small caps trailing large caps? That’s not just unusual; it’s approaching the level of improbable. The laws of financial physics dictate a correction. A return to some semblance of mean reversion. (Mean reversion, incidentally, is a bit like a financial homing pigeon. It always, eventually, returns to its starting point, usually covered in guano.) We’re projecting a potential 45% surge over the next few years. That translates to an average annual return of around 13%. A reasonable expectation, given the inherent value currently overlooked, and the inevitable rotation of investor attention. The past offers some clues: 75% from 2003-2005, 48% from 2009-2011, and 19% from 2016-2018 (though a late 2018 bear market briefly interrupted that particular upward trajectory). The market, like a particularly moody teenager, is prone to sudden changes of heart.

iShares Russell 2000 ETF

The iShares Russell 2000 ETF (IWM) is, let’s be honest, the default setting for small-cap exposure. It holds the next 2,000 stocks ranked by market capitalization after the Russell 1000 (those rather larger, more established entities). It’s a bit like a cosmic sorting algorithm, dividing the financial universe into manageable chunks. (Though, unlike a cosmic sorting algorithm, it’s subject to human error and the occasional regulatory hiccup.) One minor quibble: a significant portion – around 40% – of the index consists of unprofitable companies. Not ideal, perhaps, but not necessarily a deal-breaker. Unprofitable companies, under the right conditions, can be surprisingly buoyant. (Think of them as financial hot air balloons: potentially unstable, but capable of reaching impressive heights.) Since April 2025 – the date President Trump announced a series of tariffs – those unprofitable Russell 2000 components have actually outperformed their profitable counterparts by about 20%. A curious phenomenon, and one that suggests a degree of market irrationality. If we see continued lower rates, stable inflation, and earnings growth, this fund could lead the charge.

iShares Core S&P Small-Cap ETF

The iShares Core S&P Small-Cap ETF (IJR) addresses the “quality issue” of the Russell 2000. If you’re seeking small-cap exposure but prefer companies that aren’t actively losing money, this is a sensible choice. It tracks the S&P SmallCap 600 index – the 600 largest companies after those in the S&P 500 and S&P MidCap 400. The key difference? A profitability requirement. Companies must demonstrate positive earnings in the most recent quarter and positive cumulative returns over the past four quarters. This adds a layer of stability, reduces volatility, and improves key metrics like return on assets and return on equity. (It also slightly narrows the potential upside, but that’s the price of sanity.)

Vanguard Small-Cap Value ETF

The Vanguard Small-Cap Value ETF (VBR) leans further into undervalued companies. It starts with a broad small-cap universe and then filters out stocks based on valuation metrics and cash flow yield. This adds a “quality tilt,” weeding out some of the truly problematic investments. (Many small-cap value stocks trade at discounts for a reason: they’re losing money or facing bleak prospects. Cash flow yield helps identify those with at least a glimmer of hope.) Currently, the portfolio trades at around 17 times earnings – not exactly a bargain, but with potential if a market rebound occurs. (Potential, of course, is a word beloved by optimists and ignored by cynics.)

2026-02-06 14:33

iShares Russell 2000 ETF

iShares Core S&P Small-Cap ETF

Vanguard Small-Cap Value ETF

Read More