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After years of lagging behind, small-cap equities may finally be ready for a comeback. Valuations have dropped to multi-year lows compared to large-cap stocks, creating a historically attractive entry point.[1] With monetary policy expected to ease and liquidity conditions to improve, the macro environment is turning more supportive.[2]
Join our investment expert Jennifer Schmitz in this month’s Xtrackers Spotlight where we shine a light on a current investment topic for you and share insights into the latest trends in the ETF market.
The longest period of underperformance of global small caps vs large caps in the last 25 years is strongly linked to high interest rates
Historically, small caps have outperformed during cyclical recoveries and after interest rate cuts.[3] Add to that their structural advantages—such as faster earnings growth, stronger domestic focus, and portfolio diversification —and you have a potentially quite compelling investment case.[4] While small caps are known for their strong long-term return potential, they also tend to come with higher price swings.[5] Yet today, they’re in the midst of their longest underperformance streak in 25 years.
Is this a sign of structural decline—or the setup for a rebound? We believe it’s the latter.
Rising rates have historically hurt small-cap performance. But when central banks ease policy, small caps tend to recover strongly. With further rate cuts expected by both the Fed Reserve (Fed) and the European Central Bank (ECB), we may be approaching a turning point.
Relative performance in % (12m rolling in USD, lhs, in gray), Fed Funds Rate (mid) in % (rhs, in orange)
Source: DWS International GmbH, Bloomberg L.P, as of 30/06/2025. Performance numbers for World in USD. Past performance, actual or simulated, is not a reliable indicator of future results. Rhs = right-hand scale, lhs= left-hand scale
Why consider small cap now? Let’s break down the investment rationale:
1 Valuations
Small caps are trading at a rare discount to large caps globally, reversing their typical valuation premium. Historically, such valuation gaps have led to strong rebounds. While U.S. small caps still lag, European small caps have already started recovering from low levels amid improving conditions.[6]
2 Earnings Momentum
3 Macroeconomic Tailwinds
Generally, small caps are more cyclical, more domestically focused, and more sensitive to interest rates. That tends to make them prime beneficiaries of economic recoveries and easing cycles. With central banks shifting toward more accommodative stances, small caps could shine in a soft-landing scenario.[9]
4 Diversification Benefits
Small caps represent about 14 percent of the global equity universe not represented by large cap indices. Their indices are more diversified and less concentrated, reducing single-stock risk and increasing exposure to innovative companies that often fly under the radar.[10]
While Global Small Caps have continuously gotten cheaper relative to Large Caps in recent years…
European Small Caps have started re-rating this year from low levels.
Source: DWS International GmbH, Bloomberg L.P, as of 30/06/2025. Numbers for World in USD and for Europe in EUR. Forecasts are not a reliable indicator of future performance. Forecasts are based on assumptions, estimates, opinions and hypothetical performance analysis, therefore actual results may vary.
¹ Refers to Estimated P/E Next Year from Bloomberg (EST_PE_NEXT_YR_AGGTE). The Price-to-Earnings (P/E) ratio is a commonly used valuation metric that compares a company’s current share price to its expected earnings per share over the next 12 months. It is often used to assess whether a stock/index is overvalued or undervalued relative to its earnings potential. In above context, the ratio of the P/E of the MSCI Europe Small Cap Index to the P/E of the MSCI Europe Index provides a relative valuation measure between small-cap and broader European equities. A ratio above 1 indicates that small-cap stocks are trading at a premium to large-cap stocks, while a ratio below 1 suggests a discount.
In Summary
Risks for investing into small caps
- The value of an investment may go down as well as up and past performance does not predict future returns. Investor capital may be at risk up to a total loss.
- The value of an investment exposed to the currency markets which may be highly volatile. Large price swings can occur in such markets within very short periods and may result in your investment suffering a loss.
- The value of an investment in shares will depend on a number of factors including, but not limited to, market and economic conditions, sector, geographical region and political events.
- The value of an investment is exposed to market movements in a single country or region which may be adversely affected by political or economic developments, government action or natural events that do not affect a fund investing in broader markets.
- The investments into small and mid-capitalisation companies potentially involves greater risks compared to investing in large capitalisation companies. The shares may have less liquidity and could experience more price swings (or volatility) which could adversely affect the value of your investment.