European smallcaps have delivered significantly better results this year than their US counterparts. Yet smallcaps weighed on ING’s portfolio returns.
After years of underperformance, European smallcaps stood out in the first half of the year, beating US smallcaps. The gap has since narrowed, with the MSCI Europe Small Cap Index returning about 11 percent year-to-date, compared with roughly 6 percent for the Russell 2000.
According to Ryan Reardon, investment strategist at State Street, the outperformance of European smallcaps is partly due to the industrials sector, boosted by large-scale government spending plans on defense and infrastructure. “Industrials are a key beneficiary of higher expected public spending and Europe’s rearmament, and they carry significant weight in the MSCI Europe Small Cap Index and the MSCI Europe Small Cap Value Weighted Index,” said Reardon.
European smallcaps have also benefited from monetary policy. Unlike the Fed, the European Central Bank has already cut interest rates multiple times. “Smallcaps are much more sensitive to interest rates than large companies, as they typically have higher debt levels and rely more often on variable-rate financing,” Reardon explained.
Attractive valuations
Reardon also pointed to relatively attractive valuations. European smallcaps trade at a forward price-to-earnings ratio of 14 based on expected earnings over the next twelve months. For the MSCI Europe, the ratio is 15, and for the Russell 2000 it is 25. The MSCI Europe Small Cap Value Weighted Index trades at an even steeper discount, with a P/E of 11.5. That index includes the same names as the standard small cap benchmark but gives higher weights to cheaper stocks.
What also plays in Europe’s favor is the relatively strong expected earnings-per-share growth of about 15 percent in 2025 and 2026. For largecaps, growth is projected at around 11 percent. Reardon further highlights that European smallcaps have lower exposure to tariffs and currency risk, as more than 60 percent of their revenue comes from within Europe. For European largecaps, that figure is closer to 40 percent.
Downside risks are mainly tied to the macro environment, Reardon believed. An unexpected rise in inflation could force the ECB to tighten policy again, which would hit small caps disproportionately hard. This risk is even more pronounced in the US, where tariffs may fuel higher inflation and prompt a Fed policy shift. Reardon warned: “US smallcaps will correct sharply if rate cuts don’t materialize. A significant slowdown in the economy triggered by higher tariffs is also a major risk for the Russell 2000.”
ING misses the rally
Despite strong performance in Europe, smallcaps weighed on ING’s model portfolio in the first half of the year. “European smallcaps made only a limited contribution because we favored largecaps and sectors with more stable cash flows in most portfolios,” ING said in a written statement. “Returns on US smallcaps were hurt by the dollar’s decline against the euro, which had a strong negative impact for us as euro-based investors.”
“This more cautious positioning was meant to limit volatility, but it also meant we benefited less from the smallcap rally,” ING added. “Still, in the first half of 2025 we delivered the best relative returns among the five largest Dutch banks, thanks to strong choices in sector and regional allocation.”
For the rest of 2025, ING is cautiously optimistic about US smallcaps, particularly in the event of a ‘soft landing’ for the US economy and an expected Fed rate cut. At the same time, the bank sees risks due to “high valuations” and the drag of a weaker dollar on returns. “We are less positive on European smallcaps. While first-half performance was strong, our strategies continue to favor largecaps and listed real estate.”
Reardon at State Street, by contrast, saw further upside for European smallcaps, though largely sentiment-driven. “Institutional investors remain underweight in European equities, but it’s likely they will move back toward neutral given Europe’s favorable trends and low valuations. Smallcaps will benefit from that shift as well.”
Globally, smallcaps are underweighted, though Reardon has no data for region-specific breakdown. ETF flows, however, clearly show a tilt toward Europe. “So far this year, investors have put 700 million euros into European smallcap ETFs, an 18 percent increase. In the US, by contrast, there has been a net outflow of 21 percent. We expect this favorable momentum in Europe to continue.”