Why Smart Money is Moving to Small Caps: Your Guide to the Size Factor in 2025

The investment landscape has shifted dramatically. The US mega-cap tech stocks have been dominating headlines and portfolios for years and you might wonder if there’s room for anything else. But here’s what seasoned investment managers are noticing: small caps are trading at their deepest discount in two decades, and the smart money is taking notice.

In our recent Fusion Series webinar with Vanguard, we discussed why the size factor – essentially betting on smaller companies outperforming larger ones – deserves your attention right now. If you’re advising clients who are overexposed to the “Magnificent Seven” or looking for genuine diversification beyond the usual suspects, this discussion couldn’t be more timely.

Watch the full webinar above for detailed insights from our investment team and Vanguard’s experts on how to effectively capture the size premium.

The Return of the Size Premium

Let’s address the elephant in the room. Yes, small caps have underperformed recently. If you’d backed them over US tech giants in the past four years, your clients wouldn’t be thanking you. But investing isn’t about rear-view mirrors – it’s about spotting where value lies ahead.

Currently, global small caps trade at valuations not seen since the early 2000s. This isn’t just one sector having a bad day; it’s a broad derating across communications, energy, materials – essentially every sector within small caps. When everyone’s running in one direction, experienced investment managers know to look the other way.

What makes this particularly interesting is the economic backdrop. We’re seeing:

• Central banks cutting rates (small caps are more rate-sensitive than their larger peers)
• Rising trade barriers favouring domestic businesses
• A shift from globalisation to regionalisation

James, our portfolio manager, put it well during the webinar: “Smaller companies tend to be more domestically focused, less exposed to global trade complexities. In a world of tariffs and trade wars, that’s becoming an advantage rather than a limitation.”

Why Factor Investing Matters More Than Ever

Before diving deeper into small caps, it’s worth understanding the broader context of factor investing. As Ben from Vanguard explained, we’ve come a long way from the pre-1960s, when every return was attributed to manager skill.

Today, we know that systematic factors – characteristics like size, value, momentum, and quality – drive the majority of returns. The humbling truth? Manager skill typically accounts for less than 20% of performance. The rest comes from market exposure and factor tilts.

This isn’t about giving up on active management. It’s about being honest about what drives returns and positioning portfolios accordingly. When you understand factors, you can make more informed decisions about when to lean into certain exposures and when to pull back.

The Global Diversification Advantage

Here’s where many investment managers miss a trick. When adding small caps, the instinct is often to go regional – a bit of UK smaller companies here, some European small caps there. But Vanguard’s analysis reveals something compelling: going global with small caps has historically delivered better risk-adjusted returns than any single regional allocation.

Consider the numbers. The top 10 holdings in a global equity index account for nearly 25% of the index. In global small caps? Just 2%. That’s real diversification, not the pseudo-diversification of owning 10 tech giants with slightly different business models.

Moreover, with approximately 4,000 securities in a global small-cap index versus 1,300 in a typical global equity index, you’re accessing a vastly broader opportunity set. You’re not just buying smaller companies; you’re buying different sectors, different business models, and different economic exposures.

Practical Implementation for UK Advisers

So, how do you actually implement this in client portfolios? At Fusion, we’ve taken a measured approach. In our January rebalance, we allocated 4-6% to global small caps across our actively managed ranges. Not enough to derail performance if we’re wrong, but sufficient to make a difference if the size premium reasserts itself.

The key considerations we evaluated:

1. Cost efficiency – With OCFs around 30 basis points for quality index options, you’re not eroding the premium through fees
2. Tracking accuracy – The best index funds deliver the benchmark return minus costs, nothing fancy, just reliable execution
3. Global reach – Avoiding home bias and capturing opportunities wherever they arise

One crucial point from the webinar: don’t try to time factors perfectly. As we saw with value investing, factors can underperform for extended periods before roaring back. The approach that works is systematic, disciplined allocation rather than tactical jumping in and out.

The Indexing Advantage in Small Caps

This might surprise you, but the active-versus-passive debate looks different in small caps. While Goldman Sachs suggests that active managers outperform in this space, Morningstar’s data tells a different story. Over 15 years, more than 84% of active US small-cap funds underperformed their benchmark. In Europe, it’s 87%.

Why does indexing work so well here? Global small-cap investing is incredibly complex. Covering 4,000 securities across multiple markets, time zones, and currencies requires serious infrastructure. The idea that a small team can consistently identify winners across this universe is optimistic at best.

Looking Ahead: The Case for Action

We’re not suggesting you restructure entire portfolios around small caps tomorrow. But ignoring them entirely means missing a significant opportunity. With valuations at historic lows, supportive economic trends, and genuine diversification benefits, small caps deserve consideration in balanced portfolios.

The current environment – with its focus on reshoring, domestic growth, and economic uncertainty – could be the catalyst that ends small caps’ long winter. Whether you’re reviewing existing allocations or building new portfolios, the size factor merits your attention.

Key Takeaways for Your Practice

1. Small-cap valuations haven’t been this attractive in 20 years – This isn’t a momentum play; it’s a value opportunity
2. Global beats regional – Don’t overthink it with multiple regional funds when global delivers better risk-adjusted returns
3. Factor investing is about discipline, not timing – Systematic exposure beats tactical calls over the long term
4. Cost matters enormously – In a low-return world, every basis point counts, especially in more expensive areas like small caps
5. Diversification is real with small caps – You’re accessing genuinely different exposures, not more of the same

Next Steps

Want to explore how small-cap exposure could fit into your clients’ portfolios? Watch the full webinar above for the complete discussion, including detailed analysis from Vanguard’s team and our practical implementation approach.

For specific information about how we’re using global small caps within Fusion’s MPS ranges, or to discuss your client scenarios, get in touch with our team. We’re happy to share our research and discuss how these strategies might work for your practice.

Remember, the best opportunities often arise when consensus is looking elsewhere. With everyone focused on AI and mega-cap tech, small caps might be the diversification your clients actually need.

For more insights on factor investing and portfolio construction, subscribe to our adviser updates. Have questions about implementing small-cap strategies or want to request a presentation? 

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