They have been out of favour for some time, but small cap equities could be back on the menu for institutional investors.
According to a new report from Bfinance, Mind the Cap: Revisiting Small Cap Equities, the sector is hugely undervalued following a period of outperformance from their large cap counterparts particularly in the tech sector.
Looking at the MSCI World developed markets or MSCI All Company World Index including developed and emerging markets, the small cap segment has underperformed by 45-60 percentage points on a total return basis over the past decade.
This underperformance has created serious valuation differentials between small and large cap stocks, while secular trends – such as the move to passive investing – has seen institutional investors hold overweight positions in bigger companies.
Yet Robert Doyle Managing Director, Equity at Bfinance, says changing market conditions could see a major reversal in fortune for small cap stocks.
“Market dynamics appear to be changing in 2025, creating a more positive climate for the small cap sector. Following a period in which an exceptionally narrow group of mega cap companies dominated performance, a broader range of stocks are contributing to market returns in 2025. A broader base for returns tends to restore focus on company fundamentals, improving the conditions for small cap re-rating – both at stock level and for the segment overall,” Doyle says.
Further, macroeconomic trends are becoming more supportive.
Martha Brindle Senior Director, Equity at Bfinance, says: “Historically, small cap stocks have outperformed during periods of economic recovery, particularly at early and mid-stage, due to the perceived cyclicality of the market. This is particularly true when industrial activity accelerates. We note signs of this across several developed and emerging markets, with inflation moderating, supply chain pressures easing, and real interest rates apparently stabilising.”
There is also a possibility that trade tariffs imposed by the US government will work in small companies’ favour since, according to Brindle, they are often well positioned to withstand protectionism.
“Uncertainty surrounding tariffs can prove favourable for small companies that often generate more of their revenues locally and have less exposure to cross-border input costs, while large cap multinationals with complex global supply chains may be more vulnerable,” she says.
There are also shifting dynamics in the private equity space that look to benefit small caps
Doyle explains: “Arguably one of the key dynamics affecting the public small cap market over the past 15 years has been the dramatic increase in the size of the private equity market. IPO activity has been suppressed amid a surge in stay-private transactions.”
He continues: “As asset owners dedicated increasingly large allocations to illiquid investments, private equity managers worked to deploy a growing volume of dry powder and exits via public markets became comparatively unattractive. Yet there are signs of strain following a period of weaker-than-expected fundraising, deferred exits by private equity GPs and lower-than-hoped distributions of capital to investors.”
However small companies face significant challenges in keeping pace with institutional investors’ ESG investment strategies, often lacking the capability to adequately disclose and report their sustainable credentials.
Brindle says: “Smaller companies face fewer reporting obligations and often lack the internal resources or incentive to provide detailed ESG information. This is not an area where ESG can be reliably outsourced to a data provider: third-party data coverage is patchy.”
Consequently many stocks in the benchmark are unrated, while others receive poor scores due to disclosure gaps rather than material risk. Brindle says this limits the usefulness of standard screens and complicates efforts to integrate ESG systematically within small cap portfolios.
She adds: “Governance remains the most workable pillar – and the most material. But even here, red flags such as dual-share structures, limited board independence, or concentrated ownership are common. ESG integration in small caps demands greater effort, more discretion, and more tolerance for ambiguity.”
She notes that thematic ESG-related strategies in the small cap universe are growing – especially in biodiversity, clean tech, and resource efficiency, although caveats “These remain niche and require careful due diligence to separate mission alignment from marketing.”
