Small Caps Are Beating the S&P 500 — But 40% of Russell 2000 Companies Earn Nothing

The Russell 2000 index is beating the market. By a wide margin. Through late May 2026, the benchmark for U.S. small-cap equities had gained 17.7% year-to-date, compared with 9.9% for the S&P 500.

On the surface, that looks like the long-awaited small-cap renaissance that strategists have been forecasting for years. Valuations relative to large-caps sit at levels not seen in a quarter-century. Rate cuts, rotation trades, and domestic growth narratives are all pointing in the same direction. But beneath the headline return, a structural problem has been building for two decades, and it changes the calculus for investors who buy the index without looking at what is inside it.

Why 40% of Russell 2000 Companies Generate No Earnings

The single most important data point in the current small-cap debate is not a valuation multiple or a price chart. It is a profitability figure. According to an analysis cited by Morningstar, roughly 40% of companies in the Russell 2000 index currently generate no earnings whatsoever. Two decades ago, that figure stood at 17%.

Wells Fargo, in a research note that landed as the small-cap rally was accelerating, was direct about what that shift means. 'That has left public small-cap indexes with a larger share of younger, less profitable and more speculative companies,' the bank's analysts wrote. Their conclusion cut against the enthusiasm: 'While this may suggest a turning point in relative performance, we believe this recent momentum is masking weakness in underlying small-cap equity fundamentals.'

Consensus earnings forecasts for the Russell 2000 fell 7% in the first five months of 2026 through May 18, according to Morningstar. Over the same period, S&P 500 earnings forecasts rose 8%. Small-cap return on equity sat at less than 1% over the trailing 12 months through the first quarter of 2026. Those are not the fundamentals of an asset class on the cusp of a sustained earnings recovery.

How Federal Reserve Policy Amplifies the Small-Cap Risk

Small-cap companies do not finance themselves the way megacap technology firms do. Large corporations typically issue fixed-rate investment-grade bonds, locking in borrowing costs for years. Smaller businesses rely predominantly on floating-rate debt, meaning their interest expenses reset almost in real time as the Federal Reserve (the Fed) adjusts policy.

'Few segments of the equity market are as directly exposed to Federal Reserve policy as U.S. small-cap stocks,' according to analysis from Kalkine. 'This means borrowing costs for smaller businesses adjust almost immediately when the Federal Reserve changes policy rates.'

That structural sensitivity cuts both ways. When the Fed tightened aggressively through 2022 and 2023, small-cap profitability compressed faster and harder than for large-caps. As of June 2026, the Fed was still maintaining elevated borrowing costs, with its dot plot projections signaling no rate cuts in the near term. Energy price pressures from geopolitical conflicts and inflation tied to massive artificial intelligence infrastructure buildouts were among the factors keeping the central bank cautious.

For the 40% of Russell 2000 constituents generating no earnings, sustained high rates are not merely an inconvenience. They represent an existential financing challenge. Companies that cannot cover their interest costs from operations must either raise equity at dilutive prices, draw down credit lines, or contract. None of those outcomes support a stock rally built on improving fundamentals.

What the Data Means for Investors Choosing Between the Index and Active Management
The current small-cap landscape presents a sharply bifurcated opportunity set, and the distinction between owning the index and owning selected names within it has rarely been more consequential.

The headline rally has drawn broad attention. The Russell 2000 was up 11% year-to-date through mid-May 2026, outpacing the S&P 500's 7.7% gain over the same window. Rotation out of megacap technology into domestic value names appeared to be gaining institutional momentum, with signs of that shift visible as early as February 2026 when the Dow Jones Industrial Average broke through the 50,000 milestone for the first time.

Not all small-cap names are struggling with the index's profitability problem. Sezzle, a buy-now-pay-later (BNPL) fintech company classified in the small-cap segment, surged more than 86% in 2026 through the period covered by available data, according to TradingView. The company's first-quarter 2026 revenue grew 29% to $135.5 million, net income rose 41.9% to $51.3 million, and gross merchandise volume increased 37.3% year-on-year to $1.1 billion. B. Riley, the investment bank, raised its price target on Sezzle to $141 from $117 following those results, implying approximately 19% additional upside at the time of the revision. B. Riley analysts described the company as 'a high-growth buy now pay later platform that we believe is mispriced relative to its earnings power and growth trajectory.'

That kind of name exists inside the Russell 2000. So do hundreds of companies that have not generated positive earnings in years and whose survival depends on credit markets staying accessible. Owning them together through an index fund means accepting both.

Brown Advisory, the investment management firm, demonstrated in Q1 2026 that active selection within small-cap growth could add measurable value. Its small-cap growth strategy outperformed the Russell 2000 Growth index during the quarter, with particularly strong results from stock selection in information technology and energy, according to the firm's quarterly commentary. The Russell 2000 Growth index itself rallied nearly 10% to new highs before a sharp correction in the same period, illustrating how volatile passive exposure to the growth cohort can be.

The broader market backdrop adds another layer of complexity. Wall Street's first quarter 2026 earnings season was broadly described as strong, with the S&P 500 gaining double digits since the start of the year despite geopolitical headwinds. But analysts have noted that some of that earnings strength reflects supply shortages driving temporarily elevated prices and profit margins rather than durable demand growth. For small-cap investors, distinguishing between companies whose earnings power is structural and those riding a temporary pricing cycle is the core analytical challenge.