Small-, Mid-Cap Funds Outperform Corporate Goliaths

Big things come in small packages. 

While tech giants like Nvidia and Apple usually hog the limelight, small- and mid-cap stocks have quietly taken the lead this year. While large-cap indexes are up a respectable 10% on average, smaller companies are sprinting ahead. The S&P MidCap 400 is up 14%, the Russell 2000 has surged about 20%, and the S&P 600 has climbed 21%. It might be time for financial advisors to give the rest of the market a second look.

“You can’t deny the incredible returns large-cap funds have generated in recent years, and it’s hard to get clients to move away from those numbers, especially given the underperformance of small-caps over the past 10 years,” said Andrew Van Alstyne, founder of High Rock Wealth Management. Nonetheless, he sees plenty of upside in small- and mid-caps, typically allocating 20% to 25% of his clients’ portfolios to the space. “I’ve had strong confidence in this sector for a couple of years now. Even in years that small caps have underperformed, I would say that there is still a tremendous opportunity.”

Who’s Driving?

Investors are rotating away from mega-caps, and Magnificent 7 performance has remained generally flat this year. “Investors are getting cautious about AI spending at the largest companies,” said Morningstar analyst Zachary Evans, pointing out that these firms are increasingly taking on debt for AI buildouts. “The Mag 7 has led the market for the past five years, but it has started to taper off in the past several months.”

Ironically, it’s the beneficiaries of AI spending who are driving much of the growth among small- and mid-cap stocks, said Tom Maher, a portfolio manager at Hilton Capital Management. “Artificial intelligence requires real assets,” he said, pointing to engineering, materials and industrial companies. For example, his firm is a big fan of Dycom, a digital infrastructure business that builds fiber-optic networks for homes and now data centers. 

Both broad and concentrated funds are reaping the benefits. According to VettaFi data:

• The Vanguard S&P Mid-Cap 400 ETF (IVOO) is up 16% YTD, pulling in $340 million in new assets.
• The iShares S&P Small-Cap 600 Growth ETF (IJT) has jumped 24%, with $575 million in inflows.
• The actively managed Castellan Targeted Equity ETF (CTEF) has surged 34%, with $11 million in new assets.
• The iShares Morningstar Mid-Cap ETF (IMCB) is up 18%, with $8.5 million in new assets.

Quality Inspection. Despite the rally, caution is warranted. Smaller segments are highly sensitive to volatility, sticky inflation and interest rate hikes. “Rates don’t seem to be going lower anytime soon,” Evans warns, adding that these firms still compete with large-cap giants. “That’s why it’s vital to select funds focusing on businesses with durable advantages and stable fundamentals.”