myICLUB Blog

In last month’s SCI commentary, as well as in our Subscribers’ Webinar held in July (replay available on the Subscribers’ website), I reviewed the market dynamics that impact the returns of small-cap stocks in an attempt at understanding why the segment is in a stretch of market underperformance.

In the July 23, 2025, issue of Barron’s, Lewis Braham reported on research related to just that topic published in a paper entitled “Passive Investing and the Rise of Mega-Firms” by three finance professors, Hao Jiang, Dimitri Vayanos, and Lu Zheng, 

Their study addresses how passive investing affects asset prices, in particular how cash flows into passive funds (index mutual funds and ETFs) disproportionately raise the prices of large companies at the expense of small companies. The effect is even more pronounced on the market’s mega-cap darlings (the mega-cap-dominated passive investing vehicles of the paper’s title).

Put another way, the rise of indexing lifts large- and mega-cap stocks, and, conversely, reduces investor interest in small-cap stocks. Even worse, all of the cash that investors plough into index funds are not merely tracking the market, but are actively driving it higher.

As Vayanos, a professor of finance at the London School of Economics and Political Science, explains, “If an active manager thinks that a company is overvalued by the market then they may choose not to hold it at all—but a passive fund would hold it with a high weight.”

This research goes a long way to explaining how mega-caps have been riding high despite what many investors would describe as excessive valuations. Active investors and managers often look to smaller stocks for mispricing opportunities, seeking bargains, but market-cap-weighted indexes like the S&P 500 reward the largest stocks by holding them in even greater allocations. This practice effectively draws buyers away from small-caps and kneecaps the performance of these small company stocks.

For small stock investors, here is a probable explanation of why small-cap stock returns have trailed the returns of larger stocks in the last two decades, particularly since 2008 when passive inflows began trending upward at an even greater pace.

Vayanos goes still further. Investors “think of passive investing as essentially being neutral so they’re investing in a way that is agnostic,” he explained. “However, we saw that passive investing is not neutral, and the growth of passive means that the price of the largest firms in the economy rise more than smaller firms. Moreover, this effect is so strong that the market as a whole is going to rise.”

It is a sobering thought for individual stock pickers that the increasing popular of indexing is strong enough to drive the market to rise solely as a result of the flows of cash from active to passive investments.

The rise of index funds in retirement plans has triggered a noticeable phenomenon. Each month, when 401(k) contributions stream into accounts, returns on large stock rise more than the index itself (since those shares are purchased in greater proportion to smaller stocks).

There’s little chance of unwinding this pattern, as trillions of dollars are invested in index funds and ETFs. But as Lu Zheng, professor of finance at the University of California, Irvine, suggests, since low valuations and cash-flow growth often drive acquisitions, investors in small company stocks should stick to fundamentals. Companies with good cash flow engines, impressive margins, and markets for growth could be quite desirable takeover candidates.

This approach to small company analysis meshes with my earlier comments about the attractiveness to potential acquirers of many of our covered stocks. In Barron’s, Braham suggested that an active fund manager create a fund of small-cap stocks based on their desirability as acquisition candidates, and even went so far as to propose that an indexer create a benchmark made up of takeover targets that mutual fund and ETF sponsors could track.

All is not lost for small-cap investors, then. A strong focus on the fundamentals, as we always strive to implement in the SmallCap Informer, leaves open the possibility of respectable returns from the segment for savvy investors. And plenty of smaller companies are able to be amply rewarded for their success despite the market’s favor for large-caps.

In this issue of the SmallCap Informer, we introduce a biotechnology firm focused on treatments for rare neurological disorders.

Stay the course!

• DOUG GERLACH

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the current issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the 40+ high-quality small company stocks currently covered in the newsletter.