Fading small-cap premium and softer U.S. labor market

Commentary by Andrew Shuman, Director of Research, Vanguard Oversight & Manager Search

Key points

• U.S. small-capitalization stocks have underperformed large-capitalization stocks for a decade, a reversal of the historical “small-cap premium.”
• Structural challenges—including weaker profitability, sector composition differences, and greater interest rate sensitivity—have weighed on small-cap performance.
• Despite those headwinds, valuation gaps suggest small-caps may offer long-term opportunities, especially for skilled active managers and factor-based strategies emphasizing quality and valuation.

U.S. small-caps have significantly underperformed their large-cap counterparts over the last decade. This is a reversal from what investors have come to expect since the 1990s, when seminal academic research argued for the existence of a “small-cap premium.”¹ Although non-U.S. stocks—which have also lagged over the last decade—have enjoyed a resurgence in 2025, small-caps have continued to struggle despite their attractive valuations. Tariff concerns are at least partly to blame, as small-caps have historically been more cyclical and economically sensitive.

Our research, however, suggests that more structural factors may be at play. Smaller companies have deteriorated in quality compared with large-caps, as the figure below shows. Through July, almost a third of the companies in the Russell 2000 Index were loss-making based on annual earnings per share. Much of large-caps’ vaunted valuation premium appears at least partly justified by their superior profitability.

The initial public offering (IPO) market also appears to have played a part in small-caps’ underperformance. Although hundreds of young, promising small-cap companies have gone public in the past, many are now staying private for longer and going public at large-cap levels, if at all. This has led to the composition of the public small-cap universe becoming older over time. Additionally, the companies that have gone public over the last 10 years have tended to be less profitable than in prior decades. 

The historic outperformance of mega-cap technology stocks, often referred to as the “Magnificent Seven,” has played a role in the divergence between large- and small-caps. These stocks (Nvidia, Microsoft, Apple, Alphabet, Amazon, Meta Platforms, and Tesla) have accounted for half of large-caps’ annualized outperformance of around 6 percentage points over the last 10 years. Differences in sector composition between large- and small-caps have also been a driver—tech stocks comprise 37% of the Russell 1000 but just 12% of the Russell 2000.

The increase in interest rates over the last few years has weighed disproportionately on small-caps. While larger-cap companies were able to lock in low rates on very long-term debt when rates were lower, many small-cap companies with short-term debt structures have had to roll over their debt at higher interest rate levels. This has led to an increase in the percentage of small-caps with an interest coverage ratio (operating income divided by interest expense) of less than 2, a level generally considered safe as it means a company is earning at least twice what it needs to cover its interest payments.

Against this challenging backdrop, active small-cap fund managers have fared much better than their large-cap counterparts.² Actively managed small-cap funds tend to have a quality bias, with underweights to loss-making companies, which has been a consistent tailwind for them.

The decline in small-cap valuations has been warranted, arguably, by their decline in quality. The question now is whether the repricing has gone too far, with expectations for small-caps too bearish and those for large-caps too lofty. Looking at the price-to-earnings data another way, even when limiting the universe to “quality” companies (those with returns on invested capital of more than 20%), small-cap stocks appear very cheap compared with large-caps of comparable profitability. 

Our capital markets forecasts suggest that valuation differences have indeed grown too wide. We expect small-caps to outpace large-caps by an annualized 1.9 percentage points over the next decade. However, some caution is warranted given the prevalence of small-cap companies with weak profitability and risky balance sheets. Investors may want to consider low-cost active funds where skilled managers can be selective or funds employing factor-based strategies emphasizing quality and valuation.

Key points

• Concerns about a softening economy intensified after July 2025’s downward revisions to the U.S. labor market report, driving Treasury yields lower and raising expectations for a Federal Reserve rate cut in September.
• Inflation, which may remain sticky as tariffs take hold, adds a layer of complexity to the Fed’s policy decisions.
• Corporate earnings, especially those of large tech companies, remained strong in the second quarter. We foresee a measured softening in the economy.

The U.S. labor market report for July 2025 surprised investors much like the July 2024 report did. Both reflected less job creation than expected. Both revealed downward revisions to prior-month job-creation figures and a moderate increase in the unemployment rate. And both triggered dovish shifts in monetary policy expectations, with U.S. Treasury yields falling across the curve. 

Yet despite the similarities, there are clear differences. The muted job gains in July 2024 were perceived then as a bump in an otherwise strong labor market. The economy was deemed to be in sufficiently good health. A 50-basis-point Federal Reserve interest rate cut in September was made possible by inflation that was trending steadily downward with no reflation risk in sight.

Now, markets again expect a September rate cut, placing the probability around 80%, up from 40% the day before the labor report’s release. It would be the first cut since December 2024. But this time, a cut is more likely to reflect a weakening trend in a U.S. labor market characterized by downward revisions eroding confidence and job growth faltering. Also, the economy is facing stickier inflation and potentially higher price-stability risk, given the anticipated effects of tariffs. The Fed faces mounting challenges and expectations to recalibrate its policy stance.

Whether recent labor market developments mark the beginning of a broader slowdown or a temporary blip remains to be seen. (Our U.S. economic outlook includes our year-end forecasts.) For now, caution remains the prevailing sentiment.

Ultimately, corporate earnings play a major role in shaping risk sentiment. In 2024, the third-quarter earnings season reassured investors. Driven by big tech companies, it’s doing the same in 2025. Although we see a measured softening in the labor market and the broader economy, as well as the potential for a small struggle with inflation, we don’t foresee recession around the corner. 

—Giulio Renzi-Ricci, Vanguard Head of Portfolio Construction, Europe

We’re likely to see modest economic growth along with further rate cuts by a number of central banks before the end of 2025. But that will depend in part on how resilient markets are in absorbing tariff-related pressures.