Mean reversion, the tendency for asset prices to return to their long-term average, is a wonderful thing. However, sometimes the pendulum swings so far in one direction, it can feel like things are never going to come right.

One example of this currently is the relative underperformance of smaller company stocks versus large caps in many parts of the world.

Small caps are usually reckoned to outperform larger stocks over the long term. A simple explanation for this is that they have a greater potential for growth. ‘Elephants don’t gallop,’ as Ashe Windham, chair of Miton UK Microcap (MINI ), said recently.

There is a risk/reward argument for this too. Small-cap stocks are riskier than large caps for a variety of reasons. For example, they are less well-capitalised and so more vulnerable to downturns, find it harder to obtain debt finance, are more dependent on a single product or service, and more reliant on founders and key persons.

Rational investors – of whom there don’t seem to be many – should demand a higher return for backing a riskier company.

In the UK, the FTSE Small Cap ex-Investment Trust index outperforms the FTSE 100 over most time periods. In terms of underlying growth in net asset value (NAV), over 10 years the median UK small cap trust Henderson Smaller Companies (HSL ) has returned 108%. In the UK All Companies sector the median trust is Aurora (ARR ) which has returned 74%.

However, the smaller end of the small-cap sector – AIM stocks and microcaps – has not delivered. Again, over 10 years, the FTSE AIM index lags the FTSE 100 by about 4.8% per year on average. MINI is not 10 years old yet, but over five years it is a long way behind the median UK small cap trust, which again is Neil Hermon’s Henderson Smaller Companies.

You could try to construct an argument that investors feel that the outlook for very small UK companies is worse than it was five years ago. However, a simpler explanation is that wealth managers and others have introduced ever higher minimum market sizes on funds and are ignoring the attractions of the sector.

This has opened up a chasm in financing available for growing UK companies and is contributing to the slow death of the UK stock market. Fortunately, the problem has been recognised and it may be that measures taken to fix the problem are the catalyst that this part of the market needs for a renaissance.

In Japan, the gap between the MSCI Japan Small Cap index and its large-cap equivalent is about 12% over the past year. The Japanese corporate governance story has helped attract significant capital to the country but, for now, this has been mainly focused in large caps.

AVI Japan Opportunity (AJOT ) and Nippon Active Value (NAVF ) have delivered returns that are well ahead of Japanese small cap benchmarks, but more large cap focused funds such as CC Japan Income & Growth (CCJI ), Schroder Japan (SJG ), and more recently JPMorgan Japanese (JFJ ) have been outperforming them.

At some point it seems likely that the small caps will catch up again. Unusually, small-cap valuations are already quite a way behind those of large caps.

In the US, the Russell 2000 index has underperformed the S&P 500 by 5.3% per year on average over the last 10 years. That masks three distinct periods. In the first of these ending in July 2018, small caps kept pace with large caps. Then, concerns about economic growth and interest rate rises weighed on small caps. There was a strong small cap rally after the Covid panic (coincident with interest rates being slashed) but that has faded since about March 2021 as the cost of borrowing has started to rise and the economy slowed.

This all evidences the points that I made earlier about why small caps are riskier than large ones. However, these factors are cyclical and, despite many disappointments on the pace and likely magnitude of rate cuts, it still seems likely that they have peaked for now. It is a similar story in Europe but with the added bonus that rates have already started to fall.

For the most part, the small-cap trusts have been good about buying back stock and so there are no particular bargains from a discount point of view. I looked at the two US small-cap trusts in April. JPMorgan US Smaller Companies (JUSC ) still has better long-term performance than its rival Brown Advisory US Smaller (BASC ).

In Europe, there is a wider choice and the one you pick might depend on your view of growth stocks. Over 10 years European Smaller Companies Trust (ESCT ) has just beaten Montanaro European Smaller (MTE ), which has had a tougher time of late.

The unusual factor at work in both Europe and the US has been investors’ fixation on a narrow group of very large stocks – such as those associated with AI and obesity drugs. This has exacerbated the relative underperformance of small caps. Periods of small-cap underperformance also tend to strengthen the arguments against active management and the ‘Magnificent Seven’ mania has made that worse. Hopefully, soon the tide will turn back and reward active fund managers once again.

James Carthew is head of research at QuotedData.

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