
Bull vs. Bear is a weekly feature where the VettaFi writers’ room takes opposite sides for a debate on controversial stocks, strategies, or market ideas — with plenty of discussion of ETF ideas to play either angle. For this edition of Bull vs. Bear, Karrie Gordon and Nick Peters-Golden discussed U.S. vs non-U.S. small-caps.
Nick Peters-Golden, staff writer, VettaFi: Hi Karrie! So excited to be getting our Bull vs. Bear series back into gear. For me, the start of 2025 is all about small-caps. Small tech, small financial firms, small health, and biotech firms all offer some notable upside. Rate cuts are still working their way through the financial system, potentially offering cheaper borrowing for those companies. What’s more, deregulation could help some of those firms really meet their goals.
That said, risks remain. It’s one thing to want to add small-caps. It’s another to find the right ones. I contend that the real small-cap upside isn’t in U.S. equities, but abroad. We’ll get into it more, I’m sure, but for me, domestic risk and global macrotrends in supply chains underlie a strong case for foreign small caps.
Karrie Gordon, staff writer, VettaFi: Nick, it’s great to be back doing Bull vs. Bear with you. It’s not even the end of January, and it’s already felt like an entire year compressed into less than a month. Volatility, the mainstay of markets, picked up drastically this week, and risks seem so pervasive this year. You wouldn’t think it’s the kind of environment in which I’d look to small-caps, but there are a lot of factors possibly working in their favor this year.
I have to say that I disagree with you that the opportunity lies outside the U.S. when it comes to small-caps. I think there’s enough added risk in international exposures that U.S. small-caps may be particularly insulated against, which makes them appealing this year. Between that and the outperformance potential of U.S. small-caps specifically this year, I don’t know if you’ll be able to convince me that looking abroad is the answer.
Diversifying Beyond Your Home Bias
Peters-Golden: First of all, I’d like to explore diversification overall. U.S. investors have benefitted from their significant home bias — there’s no denying that. However, past performance does not guarantee future results, as investors have heard repeatedly. Home bias feels great as long as it pays, but in the long term, diversification eventually pays off.
Given that trying to time markets isn’t exactly a safe strategy, it makes sense, then, to be at least somewhat diversified most of the time. Revisiting the specifics of the moment, however, one can find an especially strong overall case to diversify away from such a heavy U.S. lean.
For one, U.S. equity valuations relative to bonds are as expensive as they’ve been since before the dot-com bubble, according to the Financial Times. Last year, that continued growth relied on an outsized contribution from just a few tech firms. Those companies have ridden the huge promise of AI to new heights, but concerns remain that AI has yet to deliver revenue to match firms’ lofty promises therein.
It’s that concentration risk from tech, threatening the broader market, that speaks to diversifying. It’s more than diversifying into small-caps, however. U.S. small-caps would likely feel the pain of a tech implosion, too, especially given how tech-oriented many small firms are.
Outside of that contagion, however, domestic small-caps face an uncertain policy outlook. The new administration may have excited deregulation-hungry investors in November, but tariffs remain a distinct possibility. Firms can pass those costs on, but tariffs on key markets in Canada and Mexico and farther afield could put significant pressure on costs and supply chains. What’s more, retaliatory tariffs, too, could take a bite out of firms’ bottom lines.
Enhance U.S. Equity Diversification With Small-Caps
Gordon: U.S. small-caps offer strong diversification potential for investors feeling the current cost of market cap concentration but wanting to retain U.S. exposure. The sell-off of AI stocks on Monday sent major indexes plummeting, with the Nasdaq Composite dropping 3.1% and the S&P 500 falling 1.5%. Nvidia plummeted 17% in trading, shedding over half a trillion dollars in a single day, with WSJ reporting a total market loss of $1 trillion on Monday.
Large- and megacap tech stocks drove much of U.S. market performance in the last year, all while concentration grew. As of the end of December, nearly one-third (32.5%) of the S&P 500’s weight was allocated to one sector, information technology, according to S&P Global data.
You mentioned that U.S. tech implosion would likely trickle down to small-caps. I won’t deny that potential, but I do want to underscore the greater diversification inherent to U.S. small-caps. The Russell 2000 Index offers notable diversification across sectors, including significantly smaller tech exposure. In fact, it offered less than half that of the S&P 500, at 11.67% weight as of the end of December, according to FTSE Russell. It’s worth also mentioning that the small-cap Index declined 1% in Monday’s rout.
Putting aside the AI implosion this week, the business outlook for the U.S. appears positive this year, with manufacturing already off to a strong start. VettaFi’s Jennifer Nash recently highlighted the results of the January Texas Manufacturing Outlook Survey. The survey came in at the highest level since October 2021. Texas manufacturing currently makes up approximately 11% of all manufacturing in the U.S.
S&P Global reported that U.S. factories feel optimistic about supportive policy support for business from the new administration. In January, the flash PMI for U.S. manufacturing revealed growth after six months of contraction. Increased reshoring and nearshoring efforts will also potentially benefit manufacturing/industrials and small-caps as a whole. Industrials represented the largest sector by weight in the Russell 2000 at 19.38% as of the end of December.
Reshoring and Valuations of International Small-Caps
Peters-Golden: That’s enough from me about the case to avoid other equities. Instead, let’s focus on the positives in foreign small-caps. From Europe to Japan and emerging markets like India to South America, various regional and national markets offer intriguing opportunities.
First of all, it’s important to take stock of one of the more intriguing macrotrends out there, in the form of shifting supply chains. Since the pandemic, many global companies have revisited how their supply chains work. That does not only include reshoring certain companies nearer to the destination of their products, as in Mexico, but also a growing focus on emerging markets in Southeast Asia, for example.
That shift may focus primarily on logistics companies, but other firms in emerging markets will benefit too. That realignment also coincides with the rise of an increasingly powerful and wealthy middle class in countries like India. With more and more spending power and an ever-growing number of aspiring entrepreneurs, foreign small-caps can offer some real upside.
Perhaps most exciting about foreign small-caps, however, is their own valuations. Contrary to red hot U.S. equity valuations, non-U.S. small-caps are trading at their cheapest valuations compared to large-cap stocks in 15 years, per T. Rowe Price analysis
It’s that low cost and overall upside that has me excited. Indian small-cap firms, for example, may be poised to benefit from steady governance, that rising middle class, and of course, foreign investment. Looking ahead, an ETF investing in foreign small-caps could leverage strong research capabilities to outperform abroad. That could really help domestic bias-ridden U.S. portfolios.
Don't Bet Against the U.S. in 2025
Gordon: It’s definitely worth acknowledging the overarching uncertainty and risk so pervasive in markets. Will U.S. inflation rise? What happens if rates go up? How will geopolitical tensions escalate in known and also unpredicted arenas this year? What’s the impact on international markets and economies? How steep will tariffs actually be?
If 2024 global markets were complex, 2025 markets will be infinitely more so. However, in its 2025 global market outlook, J.P. Morgan predicts continued U.S. equity performance. Meanwhile, Europe must grapple with “structural challenges,” and emerging markets will need to navigate ongoing U.S. dollar strength and potential headwinds from shifting trade policies.

What’s more, the World Bank forecasts for slower global economic growth in the next two years, compared to pre-pandemic growth. Challenges include lower average trade growth in two-thirds of economies and insufficient per capita income growth in emerging and developing economies, resulting in a failure to bolster meaningful real economic growth. Pre-pandemic, emerging market and international equity opportunities capitalized on outsized growth, but that’s simply not the reality anymore, with the exception of a few economies.
And you can’t talk international investing without acknowledging the China-shaped elephant in the room. While China’s government remains accommodative, Vanguard predicts weaker growth for China on a number of headwinds, both international and domestic. It’s also uncertain yet how a potential tariff war with China will play out with the new U.S. administration. But concerns about a trade war with the world’s second largest economy by GDP is enough to have already spooked many U.S. investors. Many internationally focused small-cap ETFs carry some degree of exposure to China, and investors will need to decide their risk threshold when it comes to China exposures.
U.S. small-caps look to remain competitive compared to their international counterparts this year. That they could do so without carrying the added risks inherent to most international exposures in such a complex global market environment makes them worth consideration.
Active Management Matters When Investing in Small-Caps
Peters-Golden: One more item I do want to visit here is the power of active ETFs in investing abroad. Active ETFs have come on in leaps and bounds over the last few years, contributing significantly not only to new launches but also to rising ETF AUM.
Traditionally, active ETFs have played the satellite role in core and satellite-structured portfolios. While many investors may now be considering low-cost active funds for their core equity and fixed income allocations, let’s focus on those satellite allocations.
An active ETF can fill that role with distinction, especially when investing in foreign small-caps. Active ETFs frequently bring their issuer’s full research capabilities to bear, often leaning on teams of analysts who become experts in their subject areas. What’s more, those ETFs are often managed by seasoned managers who understand the idiosyncrasies of those foreign markets. They may know what to look for that junior analysts responsible for passive funds may not.
What’s more, active small-cap investing can also adapt to events, whether political or macroeconomic. That flexibility can help those funds outperform their passive peers, which often face tougher requirements before they can adjust their holdings. Finally, an active foreign small-cap ETF can pursue outperformance more aggressively than passive funds that simply try to provide a reflection of that market or category.
The Avantis International Small Cap Value ETF (AVDV ) provides a strong example of such a fund. Leaning on Avantis Investors’ capabilities, the fund actively invests in value-oriented small-cap firms exclusively outside of the United States. Charging 36 basis points, AVDV has returned 8.5% over the last one year, per Avantis Investors data. That has significantly outperformed its benchmark’s 2.7% return in that time.
Earnings Growth Potential in U.S. Small-Caps
Gordon: Plenty of ink has been spilled about the valuation gap between small-caps and large-caps in the U.S. Instead, I want talk about earnings growth estimates for small-caps this year. Broad expectations seem to reflect an anticipation of outsized earnings growth for the category this year, after two laggard years. WisdomTree and Janus Henderson both believe U.S. small-cap earnings growth could outperform, compared to the broad market and large-caps this year. It’s a sentiment shared across many 2025 U.S. outlooks.
When looking to invest in U.S. small-caps, targeted, intentional exposure may hold the key to higher return potential this year. Performance disparity between small-caps stocks is often significant. Neuberger Berman recently noted that the Russell 2000 delivered average earnings growth of 10% annually over the last 40 years. Filtering for profitable companies within the index, that number rose to 54% annually.
A focus either on quality or active management within U.S. small-caps is worth consideration in such a complex market environment. For those seeking income while screening for quality, don’t miss the WisdomTree U.S. SmallCap Quality Dividend Growth Fund (DGRS ). Meanwhile, the ALPS O’Shares US Small-Cap Quality Dividend ETF (OUSM ) focuses on high dividends, quality, and low volatility.
Those investors preferring an actively managed approach to markets should consider the Nuveen Small Cap Select ETF (NSCS ). The Neuberger Berman Small-Mid Cap ETF (NBSM ) expands into the midcap space as well, but focuses on quality and profitability.
For more news, information, and analysis, visit the Core Strategies Channel.
VettaFi LLC (“VettaFi”) is the index provider for OUSM, for which it receives an index licensing fee. However, OUSM is not issued, sponsored, endorsed, or sold by VettaFi, and VettaFi has no obligation or liability in connection with the issuance, administration, marketing, or trading of OUSM.