After years of being the market's forgotten children, small-cap stocks are back in the spotlight in 2025. But are they catching up to their older, richer S&P 500 siblings? Not a chance.

Small-cap stocks, represented by the Russell 2000 index RUT, are closing in on the S&P 500's SPX gains so far this year, raising the possibility that they could be the surprise winners of a wild year for the stock market. The Russell 2000 index is up 10% so far in 2025, while the large-cap S&P 500 has risen more than 13% in the same period, according to FactSet data.

The last time the Russell 2000 outperformed the S&P 500 on a year-to-date basis was on Feb. 6, according to Dow Jones Market Data. But the small-cap Russell 2000 hasn't outperformed the S&P 500 during a calendar year since 2020, when the small-cap index rose 18.4%, compared with the S&P 500's 16.3%.

And even that short spell of outperformance has been pretty out of the ordinary of late. Years of academic research, including papers published by famed economists Eugene Fama and Kenneth French, have shown that, over time, small caps should outperform large-cap stocks. But over the past decade or so, large caps have done decidedly better. Since Dec. 31, 2013, the S&P 500 has gained 259.7% to the Russell's 110.11%, according to Dow Jones Market Data.

Large-cap outperformance has become particularly acute since the start of the current bull market, which celebrated its third birthday last weekend. The Russell 2000 recently tallied its first record closing high in nearly four years, while the S&P 500 has been bouncing from one record finish to another since early 2024.

America's smallest public companies have been thriving this year in an economy that finally seems to reward them - lower interest rates, steady economic growth and a financial market once again hungry for risk. But beneath the surface, the fundamentals tell a different story - a reminder that the small-cap rally is being fueled more by optimism than earnings, and that these stocks may never run with the big dogs of the S&P 500.

Low quality, large returns

Among the small-cap stocks that have seen the biggest gains this year, most have one thing in common: a spotty or nonexistent track record of profitability.

Doug Ramsey, chief market strategist at Leuthold Group, told MarketWatch that the small-cap rally has been led by some of the most speculative names in the Russell 2000. According to data compiled by Aptus Capital Advisors, 43% of the companies in the Russell 2000 aren't reporting positive earnings.

But it is mostly these companies that have driven the bulk of the index's gains year to date. According to Ramsey, stocks in the Russell 2000 that don't have a reliable track record of profitability have trounced their more profitable rivals. As of earlier this week, unprofitable stocks in the Russell 2000 were up 55% year to date, compared with 8% for the profitable ones.

The difference becomes even more stark when measured from the market bottom on April 8. Since then, the unprofitable cohort has risen 108%.

"To me, it's a sign speculation is really heating up," Ramsey told MarketWatch.

This also accounts for some of the performance difference between the Russell 2000 and the S&P Small Cap 600 index SML, which has "a filtration screen for quality," said David Wagner, head of equity and portfolio manager at Aptus Capital Advisors. The S&P Small Cap 600 was up just 1.8% year to date as of Friday afternoon, FactSet data showed.

The Russell 2000 index is a purely size-based index made up of the 2,000 smallest companies in the Russell 3000 RUA by market capitalization, whereas the S&P 600 tracks approximately 600 small-cap companies that have positive as-reported earnings over the most recent quarter and the most recent four quarters, according to the official websites of the index providers.

Fed cuts drive earnings hopes

After small caps outperformed large caps during the third quarter, some analysts cited improving earnings expectations as one driver of the cohort's success.

Small-cap stocks are expected to post much stronger earnings growth than large caps in 2025, with the Russell 2000 forecast to deliver 26.5% EPS growth this year, versus 10.3% for the large-cap Russell 1000 index RUI, according to FactSet data.

But that doesn't necessarily mean the outlook for their businesses is better. One reason for the shifting expectations is that small-cap companies tend to rely more heavily on floating-rate debt, so they typically benefit the most from Fed rate cutting, which resumed in September. When interest rates fall, small caps can refinance sooner and benefit more quickly from lower borrowing costs, which could directly improve their earnings.

This means, in reality, that the latest bout of optimism surrounding small caps is likely being driven by expectations surrounding interest rates, rather than expectations that these businesses will be more competitive in the future, Aptus's Wagner said.

"Some of those small-cap companies have no earnings, and they're driven by debts to be able to come up with a new product, but that's really the main reason why small caps are expected to see better-than-expected earnings growth versus the S&P 500 in the near term," Wagner told MarketWatch in a phone interview on Thursday. "It was a rates trade, and that hasn't driven current fundamentals."

Private markets muscle in on the action

The growth of private capital is also forcing a rethink of the small-cap investment landscape, as a lot of companies with high growth potential choose to remain private rather than entering the public market as small-cap stocks, according to a recent report from Morningstar.

This could be another reason small caps have struggled to outperform their large peers over the past decade.

"Venture capital funding is keeping high-growth-potential companies private, allowing a meaningful portion of their growth to accrue outside the reach of retail investors," Zachary Evens, manager research analyst at Morningstar, said in a late September report. Meanwhile, small-cap stocks are increasingly being taken out of public markets by private-equity firms, he added.

President Donald Trump's executive order in August opening the door for everyday investors to stash their retirement savings in private equity and other alternative assets could accelerate these effects, Evens said.

"The result is a reduction in the number of public companies eligible for small-cap stock indexes, and a deterioration of the aggregate growth potential and relative quality of those companies, which contributes to bleaker sentiment among the small-cap cohort and likely to some of the underperformance for small-cap stocks," Evans said in the report.

But these headwinds haven't deterred the investors who have long focused on small caps. Francis Gannon, co-chief investment officer and managing director at Royce Investment Partners, a money manager focused on small caps, said his team has always looked at these stocks as "an evergreen asset class."

Put another way, instead of private equity and venture capital eating the publicly traded small-cap space, in reality, the opposite is happening.

"We all know that private equity has an exit problem right now, but higher-quality companies in the small-cap space that have great balance sheets, high return on investment capital, are actually being providers of liquidity to private equity" by buying portfolio companies from private equity, he told MarketWatch via phone on Thursday.

"That's a trend that really started last year and that is not recognized by the market yet," he said.