In a year when the S & P 500 is touting a 15.5% advance, small-cap stocks look underwhelming – but investors shouldn’t shy away from them, said Julie Biel, chief market strategist at Kayne Anderson Rudnick. “I don’t think you want to avoid them — they’re part of a balanced diet,” said Biel, who is also a portfolio manager at the firm. “But it’s important to recognize that part of the reason why the space is where it’s at is because earnings aren’t where they need to be.” The benchmark small-cap index Russell 2000 is up roughly 1% year to date, whereas the S & P 500 has rallied almost 16%, largely thanks to the strength of Nvidia and other megacap tech stocks. The S & P 400 mid-cap index has also fallen short of its large-cap counterpart, up a modest 5% in 2024. .RUT .SPX YTD mountain Russell 2000 versus the S & P 500 in 2024 The small- and mid-cap sector overall is more leveraged owing to its makeup — such as regional banks and real estate investment trusts — and has consequently been negatively affected by the higher rate environment. In addition, many small- and mid-cap banks own much of the commercial real estate, Biel said. The resulting “double exposure” makes sense when it comes to why investors are shunning the space, the strategist said. “Earnings in small and mid cap have not done as well; they haven’t really bottomed. A lot of these businesses don’t have the kind of market control that larger companies do and have been very hurt by inflation and higher labor costs,” said Biel. Biel herself manages a small- and mid-cap growth portfolio and takes a long-term investment approach. As of the end of the first quarter of 2024, the portfolio provided an 18.9% return on equity over five years, compared with the Russell 2500 Growth index’s 15.3% rise. The strategist said she includes businesses with earnings growth and clean balance sheets. “So if anything, they benefit when interest rates stay a little higher because they have large cash positions,” Biel said. The top five holdings in her portfolio are credit scoring company Fair Isaac , insurer Ryan Specialty , aerospace company Heico , Canadian software play Copperleaf Technologies (which is being acquired by IFS AB), and health-care products manufacturer West Pharmaceutical Services. She offered a word of caution for other investors looking to gain exposure to smaller names. “This is the time to be active if you’re invested in small and mid cap because 40% of the index is not profitable,” Biel said.