Why Are Small-Cap Stocks Underperforming? Private Markets May Play a Role.

A surge in private capital flows is incentivizing some companies to stay private for longer, intensifying business competition, and causing more public companies to be taken private. The effect: The expansion of private markets could cut into the potential of the small-cap investment space.

The decline of high-quality companies entering the market means that small-cap indexes look riskier. All the while, small-cap stock returns continue to fall behind their large-cap counterparts.

Here, we examine the role that private markets have played in the evolution of the small-cap investment space in recent years. You can also download a PDF version of this report.

Conventional theory suggests that small companies should be riskier than larger companies because their fundamentals tend to be of a lower quality and their future growth is less certain.

Indeed, in recent years, small-cap equities have shown higher risks than large-caps. These risks include weaker fundamentals, greater volatility, and deeper drawdowns.

The quality gap between the Morningstar US Small Cap Index and the Morningstar US Large Cap Index has widened since 2003—despite improvement by small caps on an absolute basis—as shown in the chart below.

Source: Morningstar Direct, author’s calculations. Data as of Dec. 31, 2025.

Recently, several mega-cap stocks with abnormally strong fundamentals have taken up a bigger portion of the large-cap index, pushing the average quality of large caps higher.

The composite quality score here reflects return on assets, return on equity, net margin, and debt/capital. Scores below zero mean that stocks in the small-cap index had weaker fundamentals, on average, than stocks in the large-cap index. A negative slope indicates those fundamentals have worsened for small caps relative to large caps.

The small-cap index has been 29.7% more volatile than the large-cap index as measured by standard deviation of returns since 1991.

The chart below shows the “volatility gap” between the two indexes. It measures the difference in each index’s rolling 12-month standard deviation of returns. Observations above zero mean that the small-cap index was more volatile than the large-cap index over the previous 12 months—which we see for most of the period examined here.

Source: Morningstar Direct, author’s calculations. Data as of Dec. 31, 2025.

After major market events or economic shocks, small-cap stocks often see deeper drawdowns than their larger counterparts. That means investors may have to wait longer for valuations to recover to their peaks, adding risk for investors with shorter time horizons.

Since 1991, the average drawdown of the small-cap index was 3.7 percentage points deeper than that of the large-cap index.

Despite the long-held belief that riskier small-caps should compensate investors with higher rates of return, small-cap US stocks have underperformed large-cap US stocks in recent years.

As small-cap returns bounce around, so does their outperformance. The Morningstar US Small Cap Index lagged the Morningstar US Large Cap Index by 49 basis points annualized, or 401% cumulatively, between January 1992 and August 2025. That means investors weren’t compensated for holding small-cap equities since 1991 despite their risky tendencies.

This trend is shown on the chart below, which illustrates the relative performance of small-cap and large-cap indexes over this period. A positive sloping line indicates that the small-cap index returned more than the large index, while a negative slope indicates the opposite. Small-cap values above 1.00 mean that the small-cap index’s cumulative return since the end of 1991 was better than the large-cap index’s cumulative return for the same period, and vice versa.

Source: Morningstar Direct. Data as of Dec. 31, 2025.

In addition to lagging the returns of large-cap stocks, the overall number of small-cap stocks outperforming the market has gone down.

Relatively few stocks tend to drive market returns. So stock returns are positively skewed, with many treading water, and just a few stars driving market-cap-weighted indexes higher. In recent years, fewer small-cap stocks have experienced these outsize returns than they used to, which has shifted the composition of US market indexes and the funds that track them.

The chart below shows that on average, the proportion of outperforming small-cap stocks has been decreasing since 2000, while the proportion of outperforming large-cap stocks has been increasing. The data points here represent the proportion of large-cap and small-cap Morningstar US Market Index constituents that performed at least one standard deviation better than the average constituent every year.

Source: Morningstar Direct. Data as of Dec. 31, 2025. Cumulative market-cap thresholds are: 70% (large cap), 80% (mid cap), remaining 10% (small cap).

Fewer stocks take up more market share than they used to. While a top-heavy market raises the bar for what it means to be a mid- or large-cap company, firms are increasingly not rising to the occasion.

The Morningstar US Market Index, which tracks the largest 97% of US stocks, included 2,169 stocks at the end of 1998. By the end of 2025, that total had fallen to 1,173 stocks—a 45.92% decline.

Most of that contraction occurred during the past seven years. By the end of 2025, three companies—Nvidia NVDA, Apple AAPL, and Microsoft MSFT—represented 25.79% of the large-cap index.

This extreme concentration has downstream effects on the makeup of mid- and small-cap indexes. Since 2018, the mid-cap index’s portfolio has shrunk by 32.04%, and the small-cap index’s portfolio has shrunk by 15.18%.

Why does this contraction happen? The US investable market shrinks when more companies become ineligible for indexes than new ones become eligible. Companies become ineligible for indexes by:

• Getting too small.
• Becoming too illiquid.
• Delisting from a US exchange, often because they merge with a private firm or another public company.

Adjusted for mergers, the number of publicly traded stocks has stayed roughly similar since 1996. This suggests that the investment universe remains robust, but the universe is spread over fewer investable stocks, consolidating investment opportunities.

Fewer stocks overall mean even fewer are driving the market higher—and those names are increasingly large. Some of the more promising small caps are being absorbed into already large public companies, taking their potential out of small-cap indexes.

Concentrated performance has another side effect.

During strong market years, the small-cap index is more likely to lose a stock because it’s ascended into the mid- or large-cap index than to receive a stock that has descended from the large- or mid-cap index.

The opposite is also generally true. During a down year, a stock is more likely to fall into the small-cap index than ascend out of it.

Lately, however, fewer firms are growing out of small-cap territory, and more companies are descending into the small-cap index. Only once in the past seven years did more companies graduate from the small-cap index than descend into it. In the preceding 20 years, this occurred 13 times.

This reversal of trend uncovers the shifting composition of the small-cap index. Instead of more companies graduating into mid- and large-cap territory as markets rise, the small-cap index is accepting more descendants from larger indexes regardless of market conditions.

If this continues, another core thesis of small-cap investing will be moot: “Tomorrow’s big stocks are today’s small stocks.”

Increasingly, tomorrow’s huge stocks are already big—so they’ll never exist as a small-cap public company.

Private markets are forcing investors to rethink the small-cap investment case.

Fewer public companies are eligible for small-cap stock indexes, and these indexes are seeing a deterioration of their constituents’ aggregate growth potential and relative quality. Recent regulatory changes that broaden access to private markets could accelerate these effects, too.

Private markets are reshaping public small-cap investing in three primary ways:

• VC funding is keeping high-growth-potential companies private, allowing most of their growth to accrue outside the reach of most investors—and outside the scrutiny of public markets.
• Record VC and PE funding is causing private firms to compete aggressively with public firms. Low-quality small-cap stocks are most vulnerable to increasing competition.
• Small-cap firms are being taken out of public markets by PE firms.

Anecdotally, it’s clear that increased venture capital funding keeps up-and-coming companies private for longer and at high valuations.

Some of the most consequential companies today have never traded in public markets but are larger than most public companies. Examples include:

• SpaceX, valued at $800 billion as of Dec. 12, 2025.
• OpenAI, valued at $500 billion as of Oct. 3, 2025.
• Anthropic, valued at $183 billion as of Sept. 2, 2025.

If publicly traded, any of these firms would be top holdings in the Morningstar US Large Cap Index.

However, the high-potential firms that often grab headlines are also anomalies. These and other founder-controlled firms are fetching extreme valuations in private markets, but most of the activity is further down the valuation ladder.

Startup firms worth over $1 billion are considered “unicorns,” and the number of unicorns has grown as VC funding swells. The Morningstar PitchBook US Unicorn Index, a benchmark that follows US unicorns, expanded its portfolio from 49 companies in June 2014 to 744 firms by the end of 2024. (Unicorns must have received at least one VC funding round in the past decade to be eligible for the Morningstar PitchBook index.)

The unicorn index is top-heavy with SpaceX and OpenAI, which are by far its largest holdings. But most of the index’s portfolio expansion in recent years has come in the would-be small- or micro-cap segment.

The Morningstar US Small Cap Index limits its portfolio to investable US stocks that fall between the 90th and 97th percentile by market capitalization. At the end of 2024, these size boundaries were roughly $12.4 billion and $3.3 billion.

About a fifth of the Morningstar PitchBook US Unicorn index’s portfolio falls within these bounds, with almost three-fourths too small to be classified as small caps. Precise classification of these companies is impossible, though, because the index accepts valuations assigned up to 10 years ago that may not reflect their real-time value as market capitalization portrays in public markets.

Nevertheless, the growth of smaller private companies is notable since most of the index’s new entrants have had financing rounds in at least the past five years.

While a popular narrative is that fewer companies are going public, and those that do are already large, small companies and their investors are still seeking exits via public markets.

PitchBook data reveals that 2021 saw a record 313 initial public offerings from VC- or PE-backed firms, and the post-money valuations of those IPOs show that most fit firmly in small-cap territory. The chart below shows that while IPO activity has slid since 2021, it remains robust, and many are still small- or micro-cap companies.

Source: PitchBook. Data as of Dec. 31, 2025.

An industry’s competitive landscape is no longer contained to public companies. Some managers note that the seemingly free flow of capital to many private firms is making it difficult for small-cap public companies to compete.

The growth of VC- or private equity-backed private companies is changing the competitive landscape of many sectors and industries. To generalize, venture capital wants growth at all costs, while public shareholders want efficient capital deployment and sturdy margins. Biotechnology is an industry acutely affected by this dynamic, causing some active fund managers to stay away entirely.

Since smaller companies tend to have fewer and weaker competitive advantages than larger companies, small-cap stocks are vulnerable to competition from privately held firms.

To combat this effect, active small-cap public stock fund managers are turning to stocks with sound fundamentals and durable competitive advantages, since those firms are less likely to lose business to VC-backed upstarts or private equity-backed turnaround stories.

This effect can be seen in small-cap indexes, too.

The Russell 2000 Index, a popular small-cap benchmark, has seen its performance slide in recent years. Relative to other major small-cap indexes, the Russell 2000 favors very small and generally low-quality stocks—companies more susceptible to the competitive pressures of growing private companies.

Conversely, the S&P SmallCap 600, an index of similarly small constituents but which requires profitability for inclusion, has handily outperformed the Russell 2000. By focusing on profitable firms, it’s more likely that S&P SmallCap 600 constituents have viable businesses and are less likely to cede market share to cash-rich private firms.

Public companies rarely go private, but it’s happening more often than it used to, and the companies taken private are larger than they used to be.

The chart below shows the number of public companies taken private and their median post-money valuation since 2006.

Source: PitchBook. Data as of Dec. 31, 2025.

The effect on the small-cap investment universe is small for now. But as private equity balance sheets grow, small-cap public companies will likely be the target of leveraged buyouts more often.

For the most part, private equity is not taking weak firms out of public markets. Of the 39 firms that were bought out of public markets in 2025, 27 had valuations of more than $1 billion, and 14 had annual revenue greater than $1 billion. The median post-money valuation for those transactions was $1.89 billion.

Recent US policy changes could be a tailwind for this emerging trend—particularly, President Donald Trump’s executive order aiming to open 401(k) plans to private assets. According to the Investment Company Institute, Americans held $8.7 trillion in 401(k) plans as of March 31, 2025, representing an enormous untapped market for private equity companies.

Even a slight uptick in private equity adoption in 401(k)s would represent a windfall for private equity funding, which is already large and growing. This could spur more deals and potentially lead to more public company buyouts by private equity firms needing to deploy new funds.

If private markets are holding back small-cap public market returns, it’s unclear if that translates to private market outperformance. If it does, then those private market returns are likely out of reach for most investors, despite the recent convergence of public and private markets.

Research finds great variability in private equity and venture capital returns, so even if “average” returns look decent, achieving the average return is likely impossible. Fund and security selection is even more important in private markets than it is in public markets because of the skewed distribution of outcomes.

Instead of making public markets more appealing for high-growth-potential private companies, the United States is slowly widening access to private markets. More capital will flow into the already large and growing areas of venture capital and private equity.

This trend may sap public markets of fresh capital and investment opportunities in publicly traded stocks with high growth potential. These effects could be felt across the US stock market, but most acutely in certain small-cap equities.

As the number of public companies consolidates, investors should be prudent.

Small-cap valuations remain low on average, and there are still opportunities in that market, but investors should be deliberate in their selection of small-cap stocks and small-cap funds. Higher-quality small-cap stocks have extended their lead and should continue to outperform lower-quality counterparts, since profitable businesses are likely better equipped to weather intensifying competition.

Many active small-cap fund managers are focusing on higher-quality companies, identifying take-private targets, and evaluating the public and private competitive landscape of each industry they invest in.

Small-cap index fund investors should prefer larger (by average market cap) and higher-quality strategies. The Morningstar Medalist Rating for funds rewards index funds like these with Silver or Gold ratings. These types of small-cap index funds hold stocks least likely to be adversely affected by the shifting landscape.

At least not yet.