Outperforming US large caps has been a challenge in recent years, particularly when companies such as Nvidia, Apple and Alphabet have been counted among that group.
But so far in 2026, US small and mid caps are putting their best foot forward, with the Russell 2000 up about 17.2%, versus a 14.3% total return from the S&P 500. Notably, the Russell 3000 ex S&P 500 has also narrowly outperformed, rising 14.9% year-to-date, according to data from FE fundinfo.
For investors such as Mark Sherlock, head of US equities at Federated Hermes, there is reason to believe this could be the start of something genuinely long-term.
“I think, historically, people have felt that US SMID was full of promise, but hadn’t delivered on it,” he told Portfolio Adviser. “My case is that we’re finally seeing that flow through.
“One never wants to become excessively bullish,” Sherlock conceded. “But I don’t think this is a one-and-done bump and then we go back to the old world.”
Nish Patel, manager of the Global Smaller Companies Trust, remains similarly bullish, arguing the market is finally showing “signs of life”, with almost half of his portfolio invested in this subsection of the market.
“A robust economy, underpinned by a solid labour market and significant investment, has combined to create a supportive backdrop — and crucially, even the prospect of higher rates and elevated bond yields hasn’t derailed the story the way many feared,” he said.
For Patel, the key feature of this rally is that it is based on earnings, not valuations.
“The difference this time is that the rotation has genuine earnings underpinning it; this is not just a valuation argument,” he told Portfolio Adviser. “Small-cap earnings have stabilised and have begun to recover, which has driven mean reversion and a narrowing of the valuation gap versus large caps.”
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Federated Hermes’ Sherlock agreed that positive earnings growth was the “key catalyst” for a genuine long-term rally in US SMID caps.
“We’re starting to see very impressive earnings growth figures, not just from smaller AI-exposed names, but also from a much wider range of companies,” he continued.
While the hyperscalers are throwing off huge amounts of cash, he argued more investors are realising this is not entirely “free cashflow” because so much of it is reinvested.
Instead, the main beneficiaries are companies further down the food chain, Sherlock continued.
“You can see this in the relative earnings growth, with the Russell 2500 having delivered superior earnings growth relative to the S&P 500.”
In fact, according to Bloomberg estimates, the Russell 2500’s earnings will outperform the S&P 500 by anywhere from 10-20 percentage points over the next few years, he explained.
“Our take would be that, based on these consensus numbers, investor sentiment will just gradually shift in favour of SMID due to the superior earnings growth.”
Greater earnings growth was supported by an increased push for diversification this year and greater market breadth, according to Patel.
“The US small-cap universe offers a natural diversification away from the concentration risk embedded in magnificent seven-heavy portfolios, and we are seeing institutional investors increasingly recognise that.”
Indeed, diversification away from crowded tech stocks has been a theme this year, with recent research from the Schroder Global Investor Insights survey finding 84% of investors were building more resilience into portfolios as almost nine in 10 feared further volatility this year.
Carly Moorhouse, senior fund analyst at Quilter Cheviot, added: “Small and mid caps provide exposure to a broader range of US-centric sectors and companies at a time when investors are increasingly looking beyond the mega-cap names that have dominated returns in recent years.”
That said, experts acknowledge that sustained performance was not guaranteed and there were areas where it was still difficult to find opportunities.
For example, while Sherlock is primarily a bottom-up stockpicker, he has zero exposure to areas such as communication services and utilities and is underweight areas such as real estate.
“It’s just difficult to find value in SMID caps in these areas, frankly,” he said. “While we do like the steady cashflows of REITs, they do tend to be very indebted and, for the past couple of years, very difficult to value.”
Similarly, Patel noted the rally has been momentum-driven in certain pockets, pointing to areas such as semiconductors, power infrastructure and construction which have all re-rated significantly.
“We are not prepared to chase momentum at any price,” he said. “Finding attractively valued entry points in those areas has been genuinely challenging.”
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