The small-cap premium is “very likely dead,” and the forces that once drove it are “either gone or overwhelmed,” according to Joachim Klement, head of strategy at Panmure Liberum.
Speaking at ETF Stream’s 2025 ETF Ecosystem Unwrapped event, Klement argued that the rise of index investing “has created a self-reinforcing loop where the largest stocks get ever larger, and the small-cap premium erodes—perhaps permanently.”
The small-cap premium concerns the historical tendency for small-cap stocks to outperform large ones over time. But as ETF Stream explored last year, the phenomenon has been weak since the 1980s and particularly so in the last decade.
For Klement, the timing of its disappearance is no coincidence: It went hand-in-hand with the rise of benchmarking and index investing.
This change in approach from the investment community has created an environment whereby small-caps exhibit lower elasticity of demand than large-caps—an observation also made by Simplify Asset Management’s Mike Green in his recent interview with ETF Stream.
Essentially, benchmarked investors are forced to hold the largest stocks in size or risk too large a tracking error. “Trust me, no risk team likes that,” joked Klement.
Given their lower elasticity, every marginal dollar into the stock market forces the price of large-caps up by a relatively greater degree, creating that “self-reinforcing” cycle of size begets size, something Green argued makes the market vulnerable to a steep market crash.
As further evidence, Klement highlighted a study which showed that stocks with high “index inclusion ratios”—in other words, those which are members of many indices such, as the Magnificent Seven—substantially outperformed companies with low inclusion ratios, a phenomenon that “exploded” in the 2010s, as the below chart shows.
Chart 1: The Index Inclusion Effect, 2000-2021—Source: Behmaram (2023)
Index inclusion “creates more automatic buying—independent of valuation—pushing prices higher. It’s artificial demand,” Klement explained.
“The study even modeled a counterfactual: What if there had been no flows into index funds and ETFs over the last 25 years? The outperformance of high-index-inclusion stocks disappears,” he added.
Despite the evaporation of the small-cap premium, Klement believes they still serve an important role in a diversified portfolio.
For one, they tend to outperform coming out of recessions because they are “more agile and quicker to adapt to changing conditions … this cyclical behaviour offers diversification benefits and, for active allocators, opportunities to adjust exposure over time.”
