Is the Russell 2000 Permanently Screwed?
I was driving recently on a sunny Hamptons afternoon, with the top down, and for some reason had chosen to mar the beauty all around with the noise of Bloomberg Radio. They were talking to investment strategist Ed Yardeni, who said something about the markets that made me instinctively hit the brake, as if his comment could kill me. In fact, what was endangered was not my physical person but my meaningful position in Russell 2000 index funds — but as with the great Jack Benny, there’s not much daylight between my money and my life.
Yardeni had been asked about the underperformance of the Russell 2000, which is comprised of small-cap stocks, vs. the S&P: 153% worse over the last ten years (6.1% annualized) and a staggering 29% over the last two alone (12.6% annualized). Generally calm, long-term oriented investors like me see this and expect the indices will revert to their historical means, and that switching after such a move may have you catching the bottom in one index relative to the other.
Yardeni, however, said that the Russell’s underperformance may now be structural. The theory is that the exponential rise of private equity funds has meant so much capital has been available to small companies that the ones with great growth prospects can fund themselves that way and never go public. This leaves as listed stocks the companies with growth that isn’t attractive enough to attract PE money.
If a founder can raise private capital to fund growth, why would they choose the hassle and cost of being publicly traded? A PE partner may better understand the founder’s medium-term strategy, compared to a stock market that will judge them based on each quarter’s results. And if employees want to sell some of their shares along the way, the rise of secondary private markets has made this more possible. Once the potential growth is mostly achieved, then they can IPO – unless they’ve been acquired first by Microsoft, J&J, or another big company.
Yardeni’s comment made such intuitive sense that after getting my car home safely I almost ran to sell all my small-cap ETFs. Instead, I raised the issue with my investment team, and my partner Steve Gorelik volunteered to do some research to see if Yardeni’s explanation is borne out by data. Steve’s writeup is below, but the short answer is it is not. And as Steve notes, even if there if there has been some validity to the private equity theory, that bottomless pool of assets has found a bottom, and sponsors are now finding it tough to raise money.1
In sum, if the small-big mean reversion discussed below has not been abolished, then there’s no need to dump IWM or other small-cap ETFs. An excellent active manager in the space may be a better choice than an unmanaged index fund, but that’s a different question.
Russell 2000 vs. S&P 500
By Steve Gorelik
In the seminal paper “Common Risk Factors in the Returns of Stocks and Bonds,” professors Eugene Fama and Kenneth French identified two factors that, over time, delivered outsized returns to equity investors — Value and Size. The rationale for the existence of these factors is the following:
— Value outperforms because cheaper stocks have fewer expectations built into them related to the growth in revenues and earnings that will come from things that are yet to happen (new products, new markets, etc.)
— Smaller companies outperform because they are riskier, and their pricing reflects higher discount rates
From 1926 until the middle of 2025, the Value factor added roughly 3.3% of annual performance, while the Size factor added a smaller but respectable 0.9%. Due to the power of compounding, small annual differences add up to significant amounts. $100 invested in the market in 1926 (dividends reinvested) would grow to $1.6 million by June of 2025. With the inclusion of the Size factor, the sum grows to $3.4 million. When the Value factor is added, the sum grows to over $59 million, but that’s a story for another time.
Despite long-term outperformance, neither Size nor Value factors add value all the time. On a 10-year rolling basis, smaller companies outperformed the broader market by as much as 100% in the 1940s when the US economy was booming thanks to the post-war economy, and again in the 1980s when the smaller companies disproportionately benefited from declining interest rates. There were also long periods of underperformance by smaller companies. In the 1950s, larger businesses did better as investors gravitated towards more stable, dividend-paying companies. Once again in the 1990s, larger firms led the market as investors were willing to put an almost infinite multiple on anything tech or .com related. In both cases, small caps rebounded strongly in the decade that followed.
In 2025, we once again find ourselves in a situation where the Size factor has underperformed for the better part of the decade, and the natural question to ask is whether a long-term investor can feel comfortable betting on reversion to the mean, or whether something about market structure makes this time different.
In a recent interview, a well-respected economist and pundit, Ed Yardeni, suggested that the Russell 2000 (a proxy for smaller companies) is fundamentally broken largely due to the emergence of private equity as a significant pool of capital that is targeting higher quality small companies, which prevents them from going public in the first place. Another argument that Prof. Yardeni makes is that the earnings growth of the Russell 2000 companies has flattened while the S&P 500 is delivering results mainly due to the fantastic performance of the Mag 7 — the largest companies in the index.
The impact of private equity money shouldn’t be ignored, but claiming that this is a structural change to the market requires a certain amount of imagination and/or hubris. Private equity funds have a finite life, and at some point, in theory, need to sell their holdings. Often, they indeed sell them to other private equity funds, but the appetite of endowments and pensions to commit ever bigger pools of capital to these vehicles seems to be waning as universities and pension funds are facing their own liquidity needs while not getting sufficient funds back from earlier investments in private equity.
The point on earnings growth is easier to examine. Between 2010 and 2024, the most recent period in which larger companies have done better, the net income of the S&P 500 grew by 185%, while the earnings of the Russell 2000 grew by 160%. The difference between the two is meaningful, but hardly enough to justify the 90% swing in relative performance between the two benchmarks over the 14 years. In the decade before, when small companies did outperform, between 1999 and 2010, the Russell’s earnings grew by 200%, while the S&P’s increased by just 72%. The difference in earnings growth is consistent with the relative performance of the two indices, with the Russell’s return exceeding the S&P’s by about 100%.
The two data points above nicely illustrate the original justification for why small companies outperform – they are riskier. When higher risk translates into higher earnings, investors benefit, but when it doesn’t, shareholders start to wonder whether the higher risk is justified.
A more interesting picture emerges when we start looking at the components of performance in the two periods (1999-2010 and 2010-2024). In its crudest form, we can deconstruct the benchmark’s performance into three parts: revenue growth, net income margin, and P/E multiple.
Between 1999 and 2010, the primary source of the Russell's performance was the change in profit margin, which went from 1.7% to 4%. The S&P, which always had more profitable companies, also improved profitability, but the change was relatively small — from 7.6% to 9.1%. Given the high multiples at which both benchmarks traded in 1999 (S&P 500 – 30x P/E, Russell – 50x P/E), both experienced multiple contraction. Still, in the case of the Russell, it managed to hold on to at least some of the gains while the S&P 500's overall absolute performance was negative for the ten-year period.
Between 2010 and 2024, the picture looks very different. Revenue growth for both were just over 100%, with the Russell delivering slightly faster growth. The profit margin expanded for the S&P 500, while it held steady for the Russell. The most important driver of the difference was multiple expansion, which contributed over 200% to the performance of the S&P 500 and 65% to the Russell.
An increase in market multiple implies that investors are more confident about the company’s or index’s ability to deliver earnings growth. In the case of the S&P 500, this confidence can be explicitly attributed to the performance of companies in the information technology sector, which grew to represent 33% of the index compared to 15% in 2010.
Going back to Dr. Yardeni’s hypothesis, is the Russell 2000 today worse than it was in 1999 or 2010? In the last 25 years, the index has compounded revenue growth at just over 4% per year. In the last 15 years, growth accelerated to just over 5% and has mostly kept pace with historical levels though, admittedly, the last couple of years have been softer. The most recent net income margin of 4.1% is not statistically different from the long-term average of 4.5%. Current operating cash flow margins are higher than historical averages. It seems that while some of the companies may be staying private for longer, the data does not indicate a significant deterioration in the quality of companies that make it into the Russell 2000.
So, if the Russell 2000 is the same as it always has been, can we comfortably claim that the S&P 500 is now a better benchmark, with its top 10 companies representing the highest weighting ever? One potentially surprising data point, given how well the largest companies’ shares have performed in the last two years, is that earnings growth since 2022 has not kept up with the increase in market value of these companies. Between 2022 and July 2025, the earnings of nine of the largest companies2 in the S&P 500 grew by an impressive $290 billion, but their combined market cap grew by over $13.3 trillion. That is a 45x multiple on incremental earnings over that time.
The higher multiples imply that prospects of the likes of Nvidia, Microsoft, Amazon, and Apple improved dramatically in the last two years, but have they? These companies are spending hundreds of billions of dollars on machine learning and are now competing more directly with each other than over the last 20 years. They would need to accelerate revenue growth and expand profit margins from already record profit levels to justify the high valuations at which they are trading.
In 1999, they didn’t.
“Private Equity Fundraising Plunges Amid Struggle to Return Cash,” Bloomberg (May 27, 2025), “Private Equity’s Fundraising Demands Far Outstrip Supply,” Institutional Investor (June 18, 2025)
Berkshire Hathaway, which is currently 8th largest by market cap, is excluded since their net income is not an appropriate measure of the company’s profitability due to mark-to-market accounting of their portfolio positions. Warren Buffett has written about this extensively in his annual letters.
Good analysis. Thanks Harvey.
Great article - does the historical margin analysis for small caps exclude loss making companies which I believe represent a larger share of the universe today vs history?