In 2025, the small-cap market continued a trend observed in the preceding years, failing to consistently outperform large-cap counterparts despite initial expectations. This period was characterized by a narrow range of market drivers, with momentum, low-quality, and high-beta factors showing strong performance. This environment presented difficulties for investment managers focused on quality, as evidenced by the fact that less than 20% of small-cap growth strategies managed to outperform. The market was marked by extreme volatility, influenced by governmental policy shifts, trade concerns, and the evolving narrative around artificial intelligence. Businesses and consumers alike exhibited caution, leading to subdued demand in many sectors. However, the overall U.S. economy demonstrated resilience with controlled inflation, enabling the Federal Reserve to implement a gradual cycle of interest rate reductions.
Despite the Russell 2000 Growth Index lagging the Russell 1000 Growth Index by a substantial margin over the full year, it matched pace in the fourth quarter. A significant development was the small-cap sector's superior earnings growth compared to large caps in the third quarter, a first in over a decade, indicating a potential shift in the asset class's financial landscape. The ClearBridge Small Cap Growth Strategy experienced a setback in the fourth quarter, primarily due to an unexpected surge in biotechnology stocks and a few underperforming information technology holdings. Specifically, the Russell 2000 Growth Biotech Index's remarkable performance highlighted the quarter's challenges. Despite this, the strategy's overall relative performance for the year was commendable, particularly given the difficult conditions for active management. The strategy's exposure to industrials, with companies like RBC Bearings and FTAI Aviation benefiting from a robust aerospace sector, and Bloom Energy thriving in the alternative power market, contributed positively. However, some software investments, such as Varonis and Wix.com, faced disproportionate market reactions to minor earnings disappointments, a common theme in the volatile small-cap environment.
Looking forward to 2026, there is considerable optimism for small-cap growth stocks, following several years dominated by concentrated market leadership. The anticipation of a broader leadership base, especially in industries like industrials, software, consumer goods, and healthcare, bodes well for diversified, quality-focused portfolios. The ongoing expansion of AI infrastructure is expected to yield visible productivity and monetization benefits across a wider array of industries, presenting new opportunities for companies leveraging AI for efficiency and product innovation. Furthermore, a resurgence in capital market activity, including initial public offerings and mergers and acquisitions, historically favors this investment strategy. This renewed activity, coupled with attractive valuations for many small-cap businesses, reinforces confidence in their underlying value. History suggests that periods of significant market dislocation often precede improved returns, positioning the small-cap asset class for stronger performance in the coming year, especially with small-cap earnings growth projected to surpass that of large-cap peers.