Persistent inflation and higher borrowing costs have weighed on smaller companies this year.

But arguably, the biggest factor has been the dominance of tech behemoths. The concentrated gains in the Magnificent Seven have distorted benchmarks like the S&P 500. Even when small- and mid-caps rally, they simply can’t match the index-level returns propelled by a few AI-driven giants.

From the April 8 low to the end of June in 2025, the Magnificent Seven advanced 37%. A lot of that gain is thanks to Nvidia, which is about 7% of the S&P 500. It added about 65% over that period. 

The AI boom could provide an edge for small caps going forward: It funnels capital into large tech names, but at the same time, it also drives speculative interest in upcoming small cap AI names. While the broader benefits of that space haven’t pushed small caps past their struggles yet, research shows there’s some hope for them yet. 

Despite recent underperformance, there is room for a rebound. First, small cap valuations are attractive: Small caps are trading at a 25% discount to large caps based on median forward price-to-earnings ratios, when looking at only profitable companies, according to our data team’s analysis. 

Many investors believe that a shift in Fed policy could be a game changer to close that gap. 

Small caps have higher interest-rate sensitivity due to their reliance on floating-rate debt. That’s because a greater percentage of the debt held by Russell 2000 companies is floating rate compared to a smaller amount for S&P 500 companies. This means that small cap companies’ interest expenses adjust more rapidly to changes in benchmark rates. So, rising rates disproportionately hurt small caps, while falling rates provide a significant boost. 

Notably, when the Fed cut rates to near-zero in March 2020 in response to the COVID pandemic, small caps saw a huge boost that carried them through the rest of the year. From the beginning of March to the end of 2020, the Russell 2000 gained around 35% while the S&P 500 gained over 25%. 

Come 2021, those gains slowed down. In 2021, the Russell 2000 gained 14% compared to the S&P 500’s 27%. 

This time, though, it could be different as smaller companies have been living under a higher interest-rate era for over three years and any rate cuts could provide some sort of lifeline by alleviating borrowing stress from balance sheets. 

Another important point is that small-cap stocks are domestically tied to the economy, which means that if inflation continues to fall, consumer sentiment improves, and GDP growth picks up, small caps could outperform. Revenue for about 80% of the companies within the Russell 2000 come from the U.S. This heavy domestic exposure not only means that an improved domestic economy would disproportionately benefit small caps, but also that they’re less vulnerable to global trade disruptions. 

The flip side of this attribute is that while small caps’ domestic focus makes them less vulnerable to global risks such as foreign currency fluctuations, geopolitical risks, and international trade dynamics, it also means their performance is more reflective of internal U.S. economic health. 

That’s why small caps have a higher sensitivity to economic cycles. Over the past 20 years, there’s been a surge in small-cap exposure to cyclical sectors such as financials, industries, materials, energy, and real estate. When U.S. economic growth accelerates, these businesses often outperform, and the opposite is true during contractions. Finally, consider that market breadth is beginning to improve. As more stocks participate in the rally, investor attention could broaden beyond the usual mega-cap names.

Coming soon: Is it better to invest passively or actively in small caps?