Debunking three myths about the US equity market

We challenge three commonly held beliefs that continue to influence investor behavior: that large caps have consistently outperformed small caps, that active management is ineffective in the US, and that adding small caps to a large cap portfolio increases overall risk.

Myth 1

Large caps have outperformed small caps in the US

We believe that recency bias – a cognitive bias that leads individuals to place too much emphasis on recent events or experiences when making decisions or judgments – may be affecting perceptions of the region. This is evident with the recent outperformance of the S&P 500, which seems to be skewing investor sentiment and overshadowing longer-term trends and historical data.

Historical data shows that for most of this century US small caps (Russell 2000) have outperformed the S&P 500 (Chart 1) [2].  

However, the most compelling returns in US equities have come from high-quality small caps – best represented by the S&P 600 [3]. Unlike the Russell 2000, which includes a significant proportion of unprofitable companies (around one-third of its constituents), the S&P 600 applies stringent inclusion criteria. These include positive earnings over both the most recent quarter and the past four consecutive quarters, a minimum market cap threshold (typically US$1 billion–$8 billion), and liquidity screens such as a minimum trading volume. These filters result in a markedly higher-quality index.

The other point to make is this is just index level data. We believe, active management has a greater chance of success lower down the market cap.

Myth 2

Active management doesn’t work in the US

This claim often stems from headline statistics focused on US large caps, where the dominance of a handful of mega-cap tech stocks has made it exceptionally difficult for active managers to outperform the S&P 500. In fact, Morningstar data shows that, net of fees, only around 4% of active US large cap managers have outperformed over the past decade [4].

But this narrative doesn’t hold across the entire market. We believe US small caps tell a very different story. With significantly less sell-side coverage, greater dispersion in returns, and more direct access to company management, the small-cap space remains fertile ground for skilled active managers. These structural inefficiencies create opportunities to uncover underappreciated, high-quality businesses.

Myth 3

Adding small cap to large cap increases overall risk

This is a common misconception. While it’s true that US small caps have historically exhibited around one-third more volatility than their large cap counterparts on a standalone basis, evaluating risk in isolation misses the bigger picture. What truly matters is how different asset classes interact within a broader portfolio.

When blended with large caps, small caps don’t lead to an increase in overall risk. This is due to the lower correlation between the two segments, which helps smooth out performance across market cycles.

Investors may sometimes ask: “How much should I allocate to small caps?” And while there’s no one-size-fits-all answer, we believe two key points are worth considering: 

In today’s environment – where market leadership is narrow and concentration risk is rising – we believe adding small caps isn’t just about chasing returns. It’s about building a more balanced, resilient portfolio.

Using that 15% rule from MSCI, we can see the impact to overall risk vs. investing 100% in large cap; an 85%/15% split equals the same risk as 100% large cap (Chart 2).  

Why we believe now is the time to diversify US equity exposure

Per Morningstar data, 66% of US large caps are allocated in index funds or passive ETFs [6]. While some ETFs are actively managed, the vast majority track the S&P 500 at a very low fee. Until recently, this passive approach has arguably been the most effective way to gain exposure to US equities – particularly given the persistent challenges faced by active large cap managers and the underperformance of small caps.

However, the exceptional returns of recent years – 23% per annum over the past three years and 14% per annum over the past 10 years – have been highly concentrated, contributing to elevated concentration risk and the well-publicised multiple expansion. While US small caps have underperformed, historical patterns (Chart 3) show that extended periods of dominance by either large or small caps are not uncommon.  

If previous market cycles are any indication, we may now be approaching the later stages of the current trend, offering a timely and compelling reason to reassess US equity allocations.

It remains too early to call, but April 8 2025 could be seen as a turning point. Since then, US small caps have outperformed their larger peers by 6%, following the market’s recovery from tariff-related lows.

We believe that the most compelling ways to diversify US equity exposure is through an actively managed small cap strategy – particularly one that combines two critical attributes investors are increasingly prioritising: 

Together, these characteristics offer not just diversification, but the potential to enhance long-term returns while reducing reliance on large-cap market dynamics.

A smarter way to evaluate returns

Trailing returns are useful in showing how a fund has performed at a one point in time but can be positively or negatively impacted by the short-medium term environment.

One could argue that the most effective way to assess fund performance is through rolling performance data. This approach captures a broader range of market conditions and reduces the influence of short-term fluctuations. It mirrors our own investment process – when evaluating whether a company merits inclusion in the portfolio, we believe it’s imperative not to focus solely on recent results. Instead, assessing how a company has performed across a variety of market environments, providing deeper insight into its potential future resilience and consistency.

A return profile with low correlation to the S&P 500

For investors looking to diversify their US equity exposure beyond a 100% allocation to large cap stocks, correlation with the S&P 500 is an important consideration. Many high-quality US small cap companies – spanning diverse industries and driven by distinct fundamentals – offer differentiated return profiles that we believe can complement large cap holdings.

Final thoughts

The US equity market continues to evolve, shaped by shifting leadership, macroeconomic forces, and investor sentiment. As this piece has explored, long-standing assumptions around performance, active management, and portfolio risk – particularly in relation to small caps – deserve a closer, more critical look. Dispelling these myths opens the door to a broader understanding of how small caps can contribute meaningfully to diversified portfolios. Looking ahead, as market dynamics normalize and valuation gaps persist, we believe small caps may be well-positioned to play a more prominent role – not just as a complement to large caps, but as a core component of long-term equity exposure.