There’s a lot of buzz about the opportunity in US small cap stocks this year. There’s a confluence of factors that seem aligned just right for the segment, chief amongst them earnings growth expectations.
Anyone who’s been watching small caps knows that the category has delivered a lot of false starts in recent years. This slice of market capitalization has underperformed large caps for about a decade. Convictions have been tested, over and over again.
In 2025, amid calls for a look at relative valuation at a time when large caps were looking frothy three years into a bull market, US small cap ETFs still faced more than $7 billion in net redemptions. The exodus came despite a pick up in performance in the second half of the year. There was little love for small caps anywhere you looked.
But, shall we dare say, this time it’s different?
According to many asset managers and market outlooks, it looks like it is. And for a few good reasons.
Robust Earnings Growth
Number one, US small caps are looking at really healthy earnings growth expectations.
The momentum really started picking up pace late in 2025. To quote a data point, courtesy of Goldman Sachs Asset Management research published last November, about 25% of Russell 2000 companies were reporting “at least” two consecutive quarters of “accelerating” earnings by that point. The momentum, the firm noted, should carry into 2026, “enabling small-cap earnings to catch up with—and potentially surpass—large caps.”
This year, estimates for small cap earnings growth are sitting anywhere between 17% and 22% in 2026, and are expected to beat large cap results.
“The focus on small caps now is really about higher earnings growth expectations, which weren’t the case early last year,” said Chris Tessin, founder and managing partner of Acuitas Investments, an institutional shop running over $1 billion in assets and a microcap fund.
“Some of the improvement in earnings has to do with the interest rate environment, as well as lower levels of regulation, and a more robust M&A environment benefiting small companies,” he added. “It isn’t simply about sentiment and people feeling good about small caps. Earrings growth is there.”
Interest Rates a Tailwind
Recent interest rate cuts and expectations for more ahead are another key factor benefiting the category.
In their published research last November, GSAM highlighted the sensitivity of small caps to rates. Crucially, it pointed out just how exposed to rates the category is vs. large caps due to the characteristics of its debt.
“With over twice the leverage of large caps and a much higher share of floating rate debt (32% for the Russell 2000 vs 6% for the S&P 500), small caps are especially sensitive to interest rate changes and stand to benefit more from rate cuts,” the firm said.
“Given that US small caps represent over 60% of the global small-cap market, the anticipated US rate cutting cycle is poised to meaningfully influence small-cap performance globally,” GSAM added.
And history is on their side, too.
According to Matt Bartolini, Head of SPDR Americas Research at State Street Investment Management, US small caps have often outperformed the S&P 500 following periods of rate cuts. (SSIM’s market outlook singled out the opportunity in small caps thanks to a “trilogy of tailwinds”: lower interest rates, end of quantitative tightening, and regulatory support in the Big Beautiful Bill, which should “flatter” these companies’ profitability.)
Valuations Remain Compelling
There’s also the issue of valuations. They remain very attractive in small cap stocks, especially considering how richly valued – or as some say “priced for perfection” – the large cap segment is.
For reference, IWM’s trailing P/E ratio currently sits at 19.6 vs. 29.9 for the iShares Russell 1000 ETF (IWB). That’s a 34% discount – a discount that has proven sticky.
When we look at the S&P index universe and compare the SPDR S&P 500 ETF (SPY) and the SPDR S&P 600 ETF (SPSM), we see small cap trailing P/E at about a 37% discount to large caps. Forward one-year P/Es are sitting at a similar gap. That’s the widest discount in about two decades.
Accessing Small Caps
Year-to-date, small caps – as measured by the iShares Russell 2000 ETF (IWM) – are up nearly 8%. The S&P 500 and the S&P 400 (large and mid-cap names) are up 1.7% and 5%, respectively, in the same period.
But, however you look at the opportunity in US small cap stocks, one thorny statistic that always comes up centers on the segment’s profitability. About 40% of the Russell 2000 consists of unprofitable names.
Valuations in the aggregate are compelling, but individually, sometimes small cap stocks are cheap for a reason.
The key message to investors around accessing this slice of the market often centers on the idea of being selective. In 2026, the call is more specifically centered on the idea of tilting towards quality.
According to SSIM data, a quality bias in index construction provides better results over time. The cumulative performance of the Russell 2000 vs the S&P 600 shows the latter has delivered an annualized 1.4% outperformance relative to the Russell 2000. The S&P 600 tilts towards quality, requiring several quarters of profitability for a name to make the cut into the benchmark.
Interestingly enough, early-year ETF asset flows show that investors are doing exactly that with both passive and active strategies. Fresh new assets have started trickling into US small cap ETFs, and the net new money is proving discerning and selective, landing in portfolios where the size factor meets quality.
Some of the biggest early-year asset creations in small cap funds are seen in the Avantis U.S. Small Cap Value ETF (AVUV), which has picked up about $270 million so far this year after bucking the outflows trend in 2025. The fund screens for quality, as in profitability, and investments, as well as valuations. It’s now a $2.2 billion ETF.
The iShares S&P Small-Cap 600 Value ETF (IJS), too, has taken in a similar amount so far this year. The competing State Street SPDR Portfolio S&P 600 Small Cap ETF (SPSM) – the cheapest S&P 600 fund at 3 basis points – has seen $220 million in net inflows in 2026. The VictoryShares Small Cap Free Cash Flow ETF (SFLO), which focuses on high quality small cap names that are attractively valued, show strong growth prospects, and have high free cash flow yield, is finding new assets as well.
What’s not gathering assets in the small cap category so far in 2026 is the iShares Russell 2000 ETF (IWM) – the broadest, popular proxy for this segment of market capitalization.
In fact, IWM currently claims the fifth largest net redemption of the year, having already seen $2.65 billion in net outflows in 2026. The bleeding comes after the fund lost $4.6 billion to net redemptions the previous year.
Conclusion
“What we are seeing so far in 2026 isn’t a ‘junk rally’ where low quality names lead, like we saw in late 2025. “We are seeing quality rank high and deliver,” Tessin noted.
“We’ve been in the small and microcap space for 15 years, and we haven’t been in an environment that always favors small caps, but it’s the richest corner of the market for excess returns,” he added. “I always try to pull back from the hype in the market about things like ‘regime change’ or ‘rotation,’ but I do think things are very well poised for small caps right now.”
Originally published on ETF Trends
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VettaFi LLC (“VettaFi”) is the index provider for SFLO, for which it receives an index licensing fee. However, SFLO is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of SFLO.
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