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Conventional theory suggests that small companies should be riskier than larger companies because their fundamentals tend to be of a lower quality and their future growth is less certain.

Indeed, in recent years, small-cap equities have shown higher risks than large-caps. These risks include weaker fundamentals, greater volatility, and deeper drawdowns.

The quality gap between the Morningstar US Small Cap Index and the Morningstar US Large Cap Index has widened since 2003—despite improvement by small caps on an absolute basis—as shown in the chart below.

Source: Morningstar Direct, author’s calculations. Data as of March 31, 2026.

Fewer stocks take up more market share than they used to. While a top-heavy market raises the bar for what it means to be a mid- or large-cap company, firms are increasingly not rising to the occasion.

The Morningstar US Market Index, which tracks the largest 97% of US stocks, included 2,169 stocks at the end of 1998. By the end of 2025, that total had fallen to 1,165 stocks—a 46.29% decline.

Most of that contraction occurred during the past seven years. By the end of Q1 2026, three companies—Nvidia NVDA, Apple AAPL, and Microsoft MSFT—represented 17.33% of the large-cap index.

This extreme concentration has downstream effects on the makeup of mid- and small-cap indexes. Since 2018, the mid-cap index’s portfolio has shrunk by 32.04%, and the small-cap index’s portfolio has shrunk by 15.18%.

Why does this contraction happen? The US investable market shrinks when more companies become ineligible for indexes than new ones become eligible. Companies become ineligible for indexes by:

• Getting too small.
• Becoming too illiquid.
• Delisting from a US exchange, often because they merge with a private firm or another public company.

Adjusted for mergers, the number of publicly traded stocks has stayed roughly similar since 1996. This suggests that the investment universe remains robust, but the universe is spread over fewer investable stocks, consolidating investment opportunities.

Fewer stocks overall mean even fewer are driving the market higher—and those names are increasingly large. Some of the more promising small caps are being absorbed into already large public companies, taking their potential out of small-cap indexes.

Concentrated performance has another side effect.

During strong market years, the small-cap index is more likely to lose a stock because it’s ascended into the mid- or large-cap index than to receive a stock that has descended from the large- or mid-cap index.

The opposite is also generally true. During a down year, a stock is more likely to fall into the small-cap index than ascend out of it.

Lately, however, fewer firms are growing out of small-cap territory, and more companies are descending into the small-cap index. Only once in the past seven years did more companies graduate from the small-cap index than descend into it. In the preceding 20 years, this occurred 13 times.

This reversal of trend uncovers the shifting composition of the small-cap index. Instead of more companies graduating into mid- and large-cap territory as markets rise, the small-cap index is accepting more descendants from larger indexes regardless of market conditions.

If this continues, another core thesis of small-cap investing will be moot: “Tomorrow’s big stocks are today’s small stocks.”

Increasingly, tomorrow’s huge stocks are already big—so they’ll never exist as a small-cap public company.

Private markets are forcing investors to rethink the small-cap investment case.

Fewer public companies are eligible for small-cap stock indexes, and these indexes are seeing a deterioration of their constituents’ aggregate growth potential and relative quality. Recent regulatory changes that broaden access to private markets could accelerate these effects, too.

Private markets are reshaping public small-cap investing in three primary ways:

• VC funding is keeping high-growth-potential companies private, allowing most of their growth to accrue outside the reach of most investors—and outside the scrutiny of public markets.
• Record VC and PE funding is causing private firms to compete aggressively with public firms. Low-quality small-cap stocks are most vulnerable to increasing competition.
• Small-cap firms are being taken out of public markets by PE firms.

Anecdotally, it’s clear that increased venture capital funding keeps up-and-coming companies private for longer and at high valuations.

Some of the most consequential companies today have never traded in public markets but are larger than most public companies. Examples include:

• SpaceX, valued at $1.25 trillion as of Feb. 2, 2026.
• OpenAI, valued at $852 billion as of March 31, 2026.
• Anthropic, valued at $380 billion as of April 20, 2026.

If publicly traded, any of these firms would be top holdings in the Morningstar US Large Cap Index.

However, the high-potential firms that often grab headlines are also anomalies. These and other founder-controlled firms are fetching extreme valuations in private markets, but most of the activity is further down the valuation ladder.

Startup firms worth over $1 billion are considered “unicorns,” and the number of unicorns has grown as VC funding swells. The Morningstar PitchBook US Unicorn Index, a benchmark that follows US unicorns, expanded its portfolio from 49 companies in June 2014 to 807 firms by the end of Q1 2026. (Unicorns must have received at least one VC funding round in the past decade to be eligible for the Morningstar PitchBook index.)

The unicorn index is top-heavy with SpaceX and OpenAI, which are by far its largest holdings. But most of the index’s portfolio expansion in recent years has come in the would-be small- or micro-cap segment.

The Morningstar US Small Cap Index limits its portfolio to investable US stocks that fall between the 90th and 97th percentile by market capitalization. At the end of 2024, these size boundaries were roughly $12.4 billion and $3.3 billion.

About a fifth of the Morningstar PitchBook US Unicorn index’s portfolio falls within these bounds, with almost three-fourths too small to be classified as small caps. Precise classification of these companies is impossible, though, because the index accepts valuations assigned up to 10 years ago that may not reflect their real-time value as market capitalization portrays in public markets.

Nevertheless, the growth of smaller private companies is notable since most of the index’s new entrants have had financing rounds in at least the past five years.

While a popular narrative is that fewer companies are going public, and those that do are already large, small companies and their investors are still seeking exits via public markets.

PitchBook data reveals that 2021 saw a record 313 initial public offerings from VC- or PE-backed firms, and the post-money valuations of those IPOs show that most fit firmly in small-cap territory. The chart below shows that while IPO activity has slid since 2021, it remains robust, and many are still small- or micro-cap companies.

Source: PitchBook. Data as of March 31, 2026.

To combat this effect, active small-cap public stock fund managers are turning to stocks with sound fundamentals and durable competitive advantages, since those firms are less likely to lose business to VC-backed upstarts or private equity-backed turnaround stories.

This effect can be seen in small-cap indexes, too.

The Russell 2000 Index, a popular small-cap benchmark, has seen its performance slide in recent years. Relative to other major small-cap indexes, the Russell 2000 favors very small and generally low-quality stocks—companies more susceptible to the competitive pressures of growing private companies.

Conversely, the S&P SmallCap 600, an index of similarly small constituents but which requires profitability for inclusion, has handily outperformed the Russell 2000. By focusing on profitable firms, it’s more likely that S&P SmallCap 600 constituents have viable businesses and are less likely to cede market share to cash-rich private firms.

Instead of making public markets more appealing for high-growth-potential private companies, the United States is slowly widening access to private markets. More capital will flow into the already large and growing areas of venture capital and private equity.

This trend may sap public markets of fresh capital and investment opportunities in publicly traded stocks with high growth potential. These effects could be felt across the US stock market, but most acutely in certain small-cap equities.

As the number of public companies consolidates, investors should be prudent.

Small-cap valuations remain low on average, and there are still opportunities in that market, but investors should be deliberate in their selection of small-cap stocks and small-cap funds. Higher-quality small-cap stocks have extended their lead and should continue to outperform lower-quality counterparts, since profitable businesses are likely better equipped to weather intensifying competition.

Many active small-cap fund managers are focusing on higher-quality companies, identifying take-private targets, and evaluating the public and private competitive landscape of each industry they invest in.

Small-cap index fund investors should prefer larger (by average market cap) and higher-quality strategies. The Morningstar Medalist Rating for funds rewards index funds like these with Silver or Gold ratings. These types of small-cap index funds hold stocks least likely to be adversely affected by the shifting landscape.

At least not yet.