Are Index Funds Ruining Small-Cap Investing?

Smaller stocks are punished because many S&P 500 index funds are market-cap-weighted. Pictured: a replica of the Charging Bull statue at a souvenir shop. (John Taggart/Bloomberg)

Many investors have long suspected that index funds aren’t just tracking the market. They’re driving it higher, and that hurts small companies.

In a paper titled “Passive Investing and the Rise of Mega-Firms,” the most recent version of which dates from March 2025, three finance professors—Hao Jiang, Dimitri Vayanos, and Lu Zheng—reveal how asset flows from active funds into passive index funds have created so-called megafirms, a phenomenon that not only distorts the largest companies’ valuations but drives the market higher overall.

The reason is that active managers tend to buy smaller stocks, looking for bargains, while S&P 500 index funds are market-cap-weighted, rewarding the largest stocks with the most assets. This shift punishes the smallest stocks, which receive the fewest assets and underperform.

Investors “think of passive investing as essentially being neutral so they’re investing in a way that is agnostic,” says Vayanos, a professor at the London School of Economics. “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.”

Index funds now dominate retirement plans—leading to passive inflows increasing early each month when many automatic 401(k) paycheck contributions occur. “Consistent with our model, returns on large stocks rise more than the index at the beginning of each month, with the effect becoming strongest when limiting the large-firm portfolio to only the largest firms,” the report’s authors write.

6 Top Active Small-Cap Funds

Even some of the best active small-cap funds have struggled to beat the S&P 500 over the past decade.

Note: Returns are as of July 18; three-, five- and 10-year returns are annualized.

Source: Morningstar Direct

With trillions now invested in index funds, it seems unlikely this trend will reverse. That has ramifications for a foundational idea of academic finance—the small-cap factor. According to Nobel laureate Eugene Fama and his research partner Ken French, small-caps should deliver a “size premium,” with better returns than large-caps over time to compensate investors for their greater risks.

But that hasn’t happened since the 2008 crash, with the iShares Core S&P 500 exchange-traded fund delivering a 852% cumulative total return from Dec. 31, 2008, through July 21, 2025, versus the 457% return for the small-cap iShares Russell 2000 ETF. This is surprising, as small-caps traditionally have led the market coming out of economic downturns.

“If you look at the mutual fund flows, the big outflows from active to passive tend to take place post-2008,” explains Jiang of Michigan State University. The study’s large-cap effect is stronger after that period.

So is the small-cap factor dead? Perhaps, if size alone is the investment criterion. “If the [shift to indexing] trend is continuing, then large-cap will have higher returns in the near future,” says Zheng of the University of California, Irvine. “Indexing is probably going to exacerbate any mispricing.”

But low valuations and cash-flow growth often drive acquisitions. Zheng suggests investors be more selective with small-caps and think long-term about the intrinsic value of the companies’ underlying businesses. What might those businesses be worth in an acquisition?

“I think for large stocks, if you want to buy the stock, you are looking for shorter-term returns,” she says. “But for small-caps…future-cash-flow analysis probably still works. Fundamentals are important.”

Though indexing to capture the small-cap factor probably won’t work, actively managed funds holding stocks of likely acquisition targets could do well. Or perhaps some indexer can create a benchmark of takeout targets for funds to track. Either could be a way to satisfy small-cap investors battered by indexes.

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