Portfolio Allocation Drift: Is It Time to Rebalance Small Cap Exposure?

Chart of the Month
Written By Jonathan M. Elliott, CPWA®, CRPC®, CDFA®, ChSNC®, CPFA™, RMA®
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Photo Credit: Roman, Unsplash

The S&P 500 has delivered strong returns over the past two years, setting 57 all-time highs in 2024 and adding more than 35 in 2025. Large-cap stocks have benefited from a combination of AI enthusiasm, resilient earnings, and strong economic growth. However, one corner of the market has been noticeably absent: small-cap stocks. While the S&P 500 climbed to new highs, the chart below shows the Russell 2000, an index of small-cap stocks, remained stuck below its November 2021 peak. The four-year drought ended this fall when small caps broke through to new highs, driven by expectations for additional Federal Reserve rate cuts.

Small-cap stocks are more sensitive to interest rates than their large-cap counterparts. Many smaller companies carry higher debt loads relative to their size and rely more heavily on borrowing to fund growth. When interest rates rise, financing costs squeeze profit margins. Conversely, when interest rates fall, the pressure eases as borrowing becomes cheaper. Small’s recent underperformance began when the Federal Reserve started its rate-hiking cycle in 2022, but it began to reverse in Q3 this year. Expectations for additional rate cuts have breathed new life into small caps. Small-cap stocks gained +12% in Q3 compared to +7.8% for large caps, the largest relative outperformance since Q1 2021. The outperformance has continued into Q4, with small caps outperforming large caps by +1.0% quarter-to-date.

Beyond the Fed's actions, valuations and investor flows tell a compelling story. Small-cap stocks trade at a significant discount to large caps, with the valuation gap at extremes. The chart below shows that small-cap ETFs have posted net outflows this year, shedding roughly $12.5 billion through October 2025. It’s the first year of net outflows since 2011. The message is clear: small-cap stocks haven't just underperformed; they've been actively avoided. Investors poured money into large-cap tech and AI-related names while small caps were left behind. The combination of depressed valuations and persistent outflows suggests these stocks are not just undervalued but genuinely unloved and underowned. This creates a potential opportunity for long-term investors.

What does this mean for your portfolio?

If you have benefited from the S&P 500's record run, the small-cap breakout raises a strategic question: Is it time to rebalance? The goal isn't to time the market but to evaluate whether your portfolio has drifted too far toward large caps and whether adding small-cap exposure aligns with your long-term goals. Small caps bring diversification at a time when the S&P 500 is highly concentrated in a few mega-cap tech names. Small caps are more domestically focused, spread across a wider range of industries, and less dependent on the AI narrative. While they are more volatile than large caps, the investment case appears to be strengthening. Fed rate cuts favor smaller borrowers, small caps trade at a steep valuation discount, and investor positioning is light. The recent breakout to new highs could mark a turning point. For those with a long-term horizon, small caps might deserve consideration in 2026.

Small Cap Stocks Surpass Previous 2021s Highs

Small Cap Stocks Surpass Previous Highs

Small Cap ETFs Experience Outflows in 2025

Small Cap ETFs Experience Outflows in 2025
 

Important Disclosures
This material is provided for general and educational purposes only and is not investment advice. Your investments should correspond to your financial needs, goals, and risk tolerance. Please consult an investment professional before making any investment or financial decisions or purchasing any financial, securities, or investment-related service or product, including any investment product or service described in these materials.

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Jonathan M. Elliott, CPWA®, CRPC®, CDFA®, ChSNC®, CPFA™, RMA®

I am currently the Managing Partner for our independent investment advisory firm, Optima Capital Management. Together with my business partners, Todd Bendell CFP® and Clinton Steinhoff, we founded Optima Capital in 2019 as a forward-thinking wealth management firm that serves as an investment fiduciary and family office for high-net-worth individuals and families. In addition to being the Chief Compliance Officer, my role at Optima Capital is portfolio management. I have over 22 years of experience in managing investment strategies and portfolios. I specialize in using fundamental and technical analysis to build custom portfolios that utilize individual equities, bonds, and exchange-traded funds (ETFs). I began my financial services career with Merrill Lynch in 2003. At Merrill, I served in the leadership roles of Market Sales Manager and Senior Resident Director for the Scottsdale West Valley Market in Arizona. On Wall Street Magazine recognized me as one of the Top 100 Branch Managers in 2017. I am originally from Saginaw, Michigan, and a marketing graduate from the W.P. Carey School of Business at Arizona State University. I am a Certified Private Wealth Advisor® professional. The CPWA® certification program is an advanced credential created specifically for wealth managers who work with high net worth clients, focusing on the life cycle of wealth: accumulation, preservation, and distribution. In addition, I hold the following designations - Chartered Retirement Planning Counselor (CRPC®), Certified Divorce Financial Analyst (CDFA®), Certified Plan Fiduciary Advisor (CPFA), and Retirement Management Advisor (RMA®). In the community, I am a member of the Central Arizona Estate Planning Council (CAEPC) and serve as an alumni advisor and mentor to student organizations at Arizona State University. My interests include traveling, outdoors, fitness, leadership, entrepreneurship, minimalism, and computer science.

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