BofA: Its 'unlikely small caps will regain their primacy in the next few years'

Investing.com -- Bank of America initiated coverage on 39 small-cap ETFs in a note Thursday, but said it remains cautious on small-caps, arguing that their historical outperformance is unlikely to return anytime soon. 

“Small cap value has outperformed all US equity factors over the past century but has lagged large cap growth by 700% since 2005,” BofA analysts wrote. 

“It seems unlikely small caps will regain their primacy in the next few years, despite bargain valuations.”

A major concern is said to be the financial health of small-cap companies. BofA notes that one-third of Russell 2000 companies are unprofitable, and nearly 70% of small-cap debt is set to mature in the next five years, which the bank describes as “an unpalatable mix in the shift from a 2% to a 5% world.” 

Higher interest rates make it more difficult for these companies to refinance their debt, limiting their growth prospects.

Structural changes in capital markets have also played a role. “The growing influence of private asset managers and megacaps fueled by passive fund flows has kept ‘best of breed’ small caps sidelined from public markets,” BofA said. 

Since 2000, 90% of venture capital-backed companies have been acquired rather than going public, while IPOs have become dominated by larger, more mature firms. Among small-cap IPOs, 55% had negative earnings in 2024.

Despite the overall pessimism, BofA highlights differences in small-cap indexes. The S&P 600, which includes a profitability filter, has outperformed the broader Russell 2000 by 1.6% annually since 1994. However, for active traders, the Russell 2000 has historically outperformed by over 10% in momentum-driven markets.

BofA identified SMLF, JSML, and SVAL as top-rated funds in broad, growth, and value categories. Multi-factor and profitability screens have historically improved returns, the firm noted.