In recent years, value stock investors have been quick to point out the risks of index funds that use market-cap weighting (like those tracking the S&P 500) allocate money based on company size. While large caps (especially mega-cap tech) dominant market performance, smaller companies have historically provided higher long-term returns to compensate investors for taking on higher volatility and risk—a concept known in finance as the size premium.
When a few massive tech giants outperform the rest of the market, as is case currently, they consume a massive percentage of the index. In these times, a so-called “diversified” fund becomes heavily reliant on just a handful of stocks. With the current market, SP 500 based indexes mean 30%+ of your money is in just 10 companies. This means the fund will swing wildly based on the performance of a few mega-cap stocks.
Alternatives to indexing based on S&P 500
- Equal-Weight Funds: Invest in versions of the index where every company gets the same exact dollar allocation. This heavily biases you towards small caps.
- Factor Investing: Allocate a portion of your money to value or small-cap funds to balance the mega-cap growth exposure. This gives you some additional small caps without over weighting to small caps.
- International Diversification: Add foreign stock indexes, which typically have less mega-cap tech concentration.
But are large cap stocks dominating the S&P 500 index necessarily a bad thing?
- Large-Caps (e.g., S&P 500): These are mature, stable businesses with global operations and massive balance sheets. They excel during economic slowdowns, periods of high interest rates, or when specific sectors like mega-cap technology experience exponential, monopolistic growth.
- Mid-Caps (e.g., S&P MidCap 400): Often called the “sweet spot” of investing, mid-caps offer a blend of financial stability and room to grow. Historically, they have frequently outperformed both large and small caps over rolling 20-year periods by avoiding the bureaucracy of giant corporations and the high failure rates of tiny ones.
- Small-Caps (e.g., Russell 2000): These are younger, nimble companies with high growth potential. They are highly sensitive to the domestic economy and tend to massively outperform during the early stages of an economic recovery or bull market, fueled by low interest rates and easier access to capital.
| Factor | Large-Caps | Mid-Caps | Small-Caps |
|---|---|---|---|
| Long-Term Growth Potential | Moderate | High | Very High |
| Volatility & Risk Profile | Lowest | Moderate | Highest |
| Economic Sensitivity | Global trends | Balanced | Highly sensitive to domestic economy |
| Historical “Size Premium” Winner | Underperforms over multi-decade cycles | Structurally strong risk-adjusted returns | Outperforms over long historical cycles |
Small caps are not necessarily better …
- The “Size Premium” Volatility: While small caps can generate higher geometric returns over 30+ years, they can go through brutal decade-long stretches of underperformance where large caps dominate completely.
- Interest Rate Sensitivity: Small and mid-cap companies typically rely more on floating-rate debt. When central banks raise interest rates, their borrowing costs skyrocket, allowing cash-rich large caps to easily outperform them.
- Survivorship Bias: Small-cap indexes suffer from higher churn. When a small company becomes wildly successful, it graduates out of the small-cap index and moves into mid or large-cap territory, leaving the small-cap index to continually cycle through unproven businesses.
