For years, global equity portfolios have increasingly gravitated towards the same destination – mega and large companies.
The Magnificent Seven now account for a significant proportion of major US equity indices, leaving many portfolios increasingly concentrated in a relatively small number of companies.
While these businesses have delivered strong returns, investors seeking diversification within their US equity allocation may be overlooking a part of the market that has historically been a powerful source of innovation, growth and active management opportunity – US micro-caps.
Often perceived as illiquid, speculative or excessively risky, the reality is that today's micro-cap universe contains thousands of established businesses operating across sectors such as health care, technology, and industrials.
For long-term investors, it represents a distinct segment of the market that can complement existing equity allocations and potentially enhance portfolio outcomes.
Here are five reasons why.
The risk is not what you think
The perception that micro-caps are inherently too risky for diversified portfolios is one of the most common reasons investors avoid the asset class but micro-caps have historically delivered a risk-adjusted return profile comparable to small-caps.
While individual companies can exhibit higher levels of volatility, the broader asset class tells a more nuanced story. Over the past 25 years, micro-caps and traditional small-caps have delivered remarkably similar rolling three-year Sharpe ratios, suggesting that investors have historically been compensated for the additional risk they have assumed.
Importantly, risk within micro-caps is not uniform. A disciplined investment process that focuses on profitable companies with strong balance sheets and sustainable growth characteristics can help avoid many of the more speculative areas of the market.
The market isn't watching
One of the defining characteristics of the micro-cap universe is how little attention it receives from the wider investment community. But limited analyst coverage creates opportunities for active managers.
The typical micro-cap company is covered by a median of just three sell-side analysts, compared with larger companies that may be followed by dozens of analysts, institutional investors and research providers.
This lack of coverage can create persistent market inefficiencies. Companies may be misunderstood, underappreciated or simply overlooked, resulting in valuation disconnects that active managers can seek to exploit.
Built for today's macro environment
Many micro-cap businesses derive most of their revenues from within the US while global markets continue to grapple with trade tensions, geopolitical uncertainty, tariffs and currency fluctuations. Against this backdrop, the domestic nature of many US micro-cap businesses are particularly noteworthy.
On average, micro-cap companies derive approximately 85% of their revenues from the US market, versus 60% for large-cap companies.
As a result, investors gain exposure to domestically driven themes such as US infrastructure spending, manufacturing reshoring, industrial investment, healthcare innovation and AI adoption, which are less dependent on international trade flows.
A gap in your small-cap allocation isn't filling
Many small-cap portfolios are no longer providing meaningful exposure to the smallest companies. Over time, many traditional small-cap managers have gradually moved up the market capitalisation spectrum. As a result, investors may have less exposure to genuinely small businesses than they realise.
Micro-caps can help address this gap. Rather than replacing a small-cap allocation, they provide complementary exposure to an often-overlooked segment of the market.
They provide access to companies earlier in their growth journey, potentially expanding the opportunity set beyond what a traditional small-cap mandate can deliver.
Small allocations can have a meaningful impact
Historical evidence suggests that even modest allocations can have a significant impact on portfolio outcomes.
When assessing any asset class, the key question is whether it improves portfolio construction. While manager selection matters, long-term outcomes are often driven more by asset allocation decisions.
Although past performance is not a reliable indicator of future results, historical evidence suggests that adding exposure to smaller companies can enhance diversification and broaden the opportunity set without materially changing a portfolio’s overall risk profile.
For investors willing to look beyond the mega-caps, the micro-cap universe may represent one of the most overlooked opportunities within US equities today.
Looking beyond the familiar
As portfolio concentration continues to rise, investors may need to look beyond the most widely owned parts of the market to uncover differentiated sources of return.
With exposure to innovative businesses, a domestic US growth profile, significant market inefficiencies and the potential to complement existing small-cap allocations, US micro-caps deserve consideration as part of a diversified long-term portfolio.
The question may no longer be whether micro-caps are too small to matter. It may be whether investors can afford to ignore them.
Rob Gordon is VAM funds investment director at Alquity Group. The views expressed above should not be taken as investment advice.