After years of lagging the S&P 500, small caps are finally having a moment again. While large caps are still mostly flat on the year, the iShares Core S&P Small Cap ETF (IJR 0.12%) is up more than 7% year to date (as of March 3, 2026).
The artificial intelligence (AI) narrative has played a big part in this. The market has begun looking at things through the lens of how industries will be disrupted by AI, not how profitable it can make the big tech companies. That has led to a major rotation away from tech and into more undervalued areas of the economy. Small caps fall into that group.
Given how long they've underperformed large caps, small caps could finally be in line for an extended stretch of leadership. Here's the investment case.
Image source: Getty Images.
Small-cap corporate earnings begin to rebound
Earnings growth is a big driver of long-term stock performance. That hasn't been a problem lately for megacap tech, but it has been for small caps. Earnings were slipping over the past few years, but that trend appears to be reversing now.
In the latter part of 2025, small-cap earnings rebounded by 27%, finally providing the fundamental rebound that could support stock price gains. With positive earnings growth and much more attractive valuations to begin with, the foundation is set for a small-cap comeback.
A strong value play
Part of the reason that large caps and tech are struggling in 2026 is because investors are questioning how much they want to pay for the growth story. If earnings momentum slows or there are questions about the health of the U.S. economy, large caps could lead on the way down.
That's not as much of an issue with small caps. The iShares Core S&P Small Cap ETF currently has a price-to-earnings (P/E) ratio of 18.5 compared to a 27.7 multiple for the iShares Core S&P 500 ETF. This deep relative discount means 1) there's a lot of value left to potentially still unlock and 2) there should be some downside protection built in because of this if conditions start to head south.
NYSEMKT: IJR
Key Data Points
Lower rates act as a tailwind
This one has become a little more iffy in the past couple of months. Toward the tail end of 2025, the market was pricing in multiple Fed rate cuts. Treasury yields also trended modestly lower. Since then, some inflation measures, such as the Fed's preferred PCE price index, have actually moved higher, not lower. Several Fed members have indicated hesitation to cut rates in light of this, and the Treasury rally has stalled.
Given its heavier reliance on debt to fund operations, small caps will take any borrowing cost benefit they can get. Rate cuts are probably still coming later this year, but the outlook is a little more cloudy.
Why the iShares Core S&P Small Cap ETF is a top choice
One of the main reasons I prefer this fund over other small-cap ETFs is that it tracks the S&P 600 index. That may not mean much on the surface, but this index has a profitability screen built into its methodology. That means investors get a quality factor with their small-cap exposure.
Given that so many small caps are unprofitable, I think this is an important quality factor to have. And it's a good reason why I would never sell this ETF.
