Historically small cap stocks have enjoyed long periods in which they outperform broader indices and larger cap indices, especially during times of economic expansion.  The theory is that smaller companies’ businesses are still in the higher growth period of their lifecycle.

But there may have been structural changes in the economy and the way investment dollars are allocated that suggest small caps may never recapture their magic.

As you can see the Russell 2000, which is comprised of companies with market caps ranging from $500 million to $6 billion, has lagged both the S&P 500 (black line) and Nasdaq 100 (red line) since 2013 when the economy was just starting to gain positive traction after the financial crisis.

The underperformance of the iShares Russell 2000 ETF (IWM)  has only worsened since the low of December a year ago.

One of the immediate causes for the divergence can be pinned on the energy sector which comprises about 18% of the Russell compared to just 5% of the S&P 500 and basically zero for the Nasdaq.

The chart below shows how far stocks in the S&P 1500 are trading relative to their 52-week highs broken out by sector.  It’s not often that you see one sector as such a big outlier relative to all the others, but the energy sector is in a league of its own these days.  Stocks in the sector are more depressed than any other, trading down an average of 42.8% from their 52-week highs.

But I think there are also structural changes that have occurred and could create a longer-term headwind for small cap stocks.

First, many companies are staying private longer and by the time they come to market with an Initial Public Offering they have already graduated to mid or even large cap status.

Second, it is starting to become a ‘winner take most’ world as technology has made given almost all businesses the potential to be global.  This means the companies that already have scale and a larger footprint have an inherent competitive edge.

It also means they are ready to gobble up smaller rivals to get access to grow, or simply absorb the technology and customers removing a potential competitor. Call it the ‘borg’ effect.

Lastly, the continued shift to passive or index based investing favors large cap companies over small cap. Large pools of money from pension and hedge funds simply find it easier to move in and out of the bigger companies.

Individual investors have been taught not to try to beat the market and just buy into low cost ETFs such as SPY and QQQ, which are both market cap weighted.

Meaning the largest companies such as Apple (AAPL) and Microsoft (MSFT) driving most of those indices gains.  Which in turn forces more dollars to be allocated these top performers in what is becoming a virtuous cycle.

It appears the big will only get bigger and small caps might be destined to lag.

SPY shares were trading at $309.32 per share on Wednesday afternoon, down $2.61 (-0.84%). Year-to-date, SPY has gained 25.49%, versus a % rise in the benchmark S&P 500 index during the same period.

About the Author: Option Sensei

Steve has more than 30 years of investment experience with an expertise in options trading. He’s written for TheStreet.com, Minyanville and currently for Option Sensei. Learn more about Steve’s background, along with links to his most recent articles. More...

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