I’m persistently asked about the relative underperformance of small-cap stocks versus their larger peers.It’s not that small-cap stocks have done badly – the Russell 2000 (RTY) is up about 18% over the past year – but their performance pales over most time periods when compared to large-cap indices like the S&P 500 (SPX). Quite frankly, there are reasons involving both economics and investor psychology.For example, here is RTY compared with SPX over the past year:

1-Year Chart, RTY (white), SPX (blue)
Source: Interactive Brokers

5-Year Chart, RTY (white), SPX (blue)
Source: Interactive Brokers
Again, it’s not as though RTY lost money, but in recent history it is obvious that it was better to have been invested in SPX than RTY.One reason that investors prefer large-cap stocks is that they have more pricing power and thus are more likely to offer consistent earnings potential.We can argue whether investors are currently overpaying for that preference, but there is a demonstrable difference in the respective companies’ earnings power and thus the indices’ valuations.SPX currently sports a P/E ratio of about 27.That is lofty by historical standards, but it pales in comparison to RTY’s 57.By that measure, SPX might not be cheap, but RTY is downright expensive.I fully understand why investors want small-cap indices to succeed.Everyone dreams of finding nascent companies, acorns, as it were, that might grow into mighty oaks.Unfortunately, that is incredibly difficult; quite frankly, investors have a much better chance with a sapling that is growing demonstrably than a fragile seedling.Then consider that even if some small caps can achieve that kind of growth, how many of them will it take to move the needle on a 2,000-stock index?Remember, the performance of RTY in early 2024 was boosted by substantial gains in MicroStrategy (MSTR) and Super Micro Computer (SMCI). The index still underwhelmed.That points out another problem with RTY: the best stocks outgrow the index. MSTR and SMCI were both “promoted” to the Russell 1000 during the last index rebalance.To extend the analogy, the Russell 2000’s mandate requires the index to sell the most prosperous saplings.Even worse, the stocks that fall below the threshold for the larger-cap Russell 1000 could end up once again in RTY. That could happen to SMCI in the spring – although to be fair, the larger cap indices bore the brunt of that stock’s recent woes.Remember also that if you are looking for small companies with potential future growth, so are private equity investors.I can’t find the statistics that might prove exactly how many RTY-style companies are in private hands rather than publicly traded, but common sense implies that a significant amount of the billions that private equity firms have used to acquire small and midsize companies has been used to snap up some of the companies that investors would most want to appear in indices like RTY. It is likely a form of negative selection by investors in small cap indices.One reason for the aforementioned disparity in index valuations is that while SPX consists primarily of profitable companies – consistent profits are a requirement for inclusion – over 40% of RTY companies are unprofitable.While that doesn’t mean that they can’t become profitable (past performance is of course no guarantee of future results), smaller companies are more dependent upon external factors than larger ones.They tend to require either a robust economy to boost their prospects or low interest rates that allow them to borrow the money necessary to keep them afloat during the lean times.Lately we have seen neither.The economy is certainly good, with 2.7% real GDP growth over the past year, but it is not roaring ahead.And while we have seen rate cuts in the past few months, the pace or short-term cuts seems to be slowing while longer rates have instead ticked higher.Those are not compelling reasons to invest in small caps.All that said, however, this is a tricky sector to bet against.And that is where its small size can be a huge advantage. The total combined market capitalization of RTY is about $3.25 trillion.That is less than Nvidia’s $3.5 trillion.We have seen how investor flows can move around a company of NVDA’s size and liquidity.Aggressive flows into RTY and its small, illiquid components can push the index higher and for longer periods of time than the index’ fundamentals might suggest.In the first chart, note the spikes in RTY that occurred in July and November.Small caps came into vogue during those periods and their index soared.Anyone who was shorting IWM, the ETF that tracks RTY, would have felt considerable pain.Even if the acorns have trouble growing into mighty oaks, it does not mean that they can’t have periodic growth spurts. More By This Author:Fun (Or Lack Thereof) With Advance-DeclinesStock Traders Once Again Reveal Their Liquidity AddictionJensen Huang’s Quantum Splash Of Cold Water