Why ASX ETFs are a threat to small-cap funds

The commencement of a global interest rate-cutting cycle is a tailwind for ASX small-cap shares after several years of underperformance.

But experts say there's one thing getting in the way of their recovery.

That's ASX exchange-traded funds (ETFs).

Here's why.

ASX ETFs attracting money away from small-caps

You see, a tonne of money is flowing into these increasingly popular investment vehicles from ordinary or 'retail' investors.

Investors love ASX ETFs because they usually track an index, thereby delivering good market-average returns over the long term.

They also enable people to buy a diversified portfolio of shares in a single trade.

They can be bought and sold just like an individual ASX share via a cheap online brokerage platform. Easy peasy.

This easiness is why the ASX ETF industry has grown by 34.8%, or $66 billion, over the past 12 months alone.

The latest estimate on the size of the ASX ETF market is $255.3 billion, according to ETF provider BetaShares.

Experts say record inflows into ETFs mean less new capital is being invested in individual rising star companies — namely, the ASX small-cap shares and the small-cap specialist funds that invest in them.

How are ASX small-cap shares performing in 2025?

ASX small-caps shares are defined as those with a market capitalisation of between a few hundred million and $2 billion.

Small-caps and their even smaller counterparts — micro-caps and nano-caps — are a huge component of the share market.

In fact, they make up about 91.5% of the 2,000 companies listed on the ASX today.

So far this year, the S&P/ASX Small Ordinaries Index (ASX: XSO), which tracks the performance of companies ranked 101 to 300 by market capitalisation in the S&P/ASX 300 Index (ASX: XKO), has fallen by 1.2%.

Although they're down, ASX small-cap shares are outperforming the benchmark S&P/ASX 200 Index (ASX: XJO), which is down 3.5%.

They're also beating the S&P/ASX All Ordinaries Index (ASX: XAO), which tracks the 500 largest companies on the market, down 3.8%.

While ASX small-cap shares are showing more resilience than larger stocks in 2025, reduced capital inflows are still working against them.

What do the experts say?

In the Australian Financial Review (AFR), Mike Henshaw from Pure Asset Management said:

The challenge for most smaller growth companies is that they need access to capital and right now they're being absolutely starved of capital.

Henshaw points out that ASX small-cap funds are receiving lower inflows from institutional investors, too.

For example, the Australian superannuation industry is allocating more money to US shares and other US assets these days following the US outperformance against the Australian share market for the past two years.

He said:

We have this huge superannuation industry investing in venture capital in the US, which has abundant access to capital, but they won't make an allocation to their home market for small caps outside the ASX 300.

There are 1,700 other listed companies which are deemed too illiquid or risky for the super industry, but AustralianSuper recently lost $1.1 billion on a private US tech stock.

Wilson Asset Management lead portfolio manager Oscar Oberg said ASX small-cap shares have underperformed ASX large-cap shares by 8% over the past four years.

But in the long term, ASX small-caps tend to outperform because they have more room for growth.

By example, the Small Ordinaries Index has lifted 39.6% over the past 10 years while the ASX 200 has risen 33.8%.

The laws of mean reversion suggest ASX small-cap shares are due for a lift.

Interest rate cuts are an obvious tailwind because smaller companies tend to carry more debt to fund their future growth.

Rate cuts reduce the cost of that debt.

As we reported back in January, Oberg makes this prediction for 2025:

We think a number of sectors within small caps that have struggled in a period of rising interest rates and cost of living pressures, such as retail, automotive, real estate investment trusts, building materials and media, will see an uplift in earnings and consequently share prices as interest rates decline.

It's worth pointing out that some ASX ETFs track small-cap companies.

One example is the VanEck Small Companies Masters ETF (ASX: MVS), which is down 1.3% in the year to date.

This ASX ETF tracks the MarketGrader Australia Small Cap 60 Index, which consists of 60 ASX small-cap shares.