Saying small-caps are down, but not out is a fair assessment. Actually, the Russell 2000 Index is up year-to-date, though its returns are less than a third of what the large-cap S&P 500 has delivered. Of course, the chasm widens over longer holdings periods.

Over the past three years, the COMBINED return of the Russell 2000 and the S&P SmallCap 600 Index is 30%, but the S&P 500 gained 54. 4% during that period. Compounding small-caps’ woes was volatility. The average annualized volatility on the two small stock gauges during those three years was north of 22% while the same metric on the S&P 500 was 17. 2%.

In other words, advisors and investors haven’t had much reason to embrace small-caps. That’s disappointing because market participants have been looking for just about any reason to reduce exposure to mega-cap growth stocks. Plus, for decades, smaller stocks outperformed larger equivalents, but phenomenon has largely had one foot in the grave for more than 10 years.

For small-cap-enthused market participants, there’s twofold silver lining. First, no one is saying smaller stocks will be moribund forever. Second, for those not willing to extend patience with small-caps, there are alternatives, including private equity.

Private Equity as Small-Cap Alternative

Arguably, private equity is playing a part in listed small-caps’ slack returns because those investors are keeping companies private longer and when they finally commence initial public offerings (IPOs), many come to market with large- or mega-cap valuations. As just two examples, if SpaceX and OpenAI were public companies today, they’d be mega-cap stocks.

“Two structural trends sit behind this shift. First, private equity financing allows younger companies to stay private longer, often achieving mid-to-large cap scale before they IPO,” notes Aaron Mulvihill, global market strategist at J. P. Morgan Asset Management. “Second, the high regulatory costs and scrutiny of public markets land hardest on smaller issuers. This combination has lowered both the quality and the number of businesses in the small-cap space. ”

As the strategist points out, the median IPO time has nearly tripled to 14 years today from five years 25 years ago. That means some enticing, high-growth firms are skipping small- and mid-cap benchmarks and going straight into large stock equivalents.

These factors are partly behind the failure of small-cap indices to deliver on their higher growth expectation relative to large caps,” adds Mulvihill. “Average US small cap revenue growth has not exceeded large cap revenue growth since 2010. ”

One of the advantages of private equity as a small-cap alternative is that those institutional investors frequently have sizable stakes in closely held tech companies – corporations that upon going public often do so with market values that are far beyond small-cap territory.

Private Equity Positives Part II

To be sure, small-caps are neither obsolete nor dead, but advisors and investors are right to be leery. Returns confirm as much and with private funds democratizing that asset class, market participants have valid reasons for considering private equity as a small-cap replacement.

“Investors value the accessibility of small cap stocks. But the advent of private equity fund structures with lower minimums has helped to level the playing field,” concludes Mulvihill. “As allocators reassess their growth equity exposure, allocating to carefully selected private equity strategies may offer superior risk-adjusted returns while capturing the dynamism that once defined small cap investing. ”