Small-cap stocks may be outperforming Wall Street's largest companies in 2026, but Wells Fargo Investment Institute believes the rally could be masking deeper weaknesses underneath the surface. This warning may be carrying growing implications for investors rotating into small-cap ETFs.

The Russell 2000 index has gained more than 17.7% so far this year, outperforming the S&P 500's 10% advance. The move has fueled renewed interest in small-cap ETFs such as iShares Russell 2000 ETF ( IWM ) , Vanguard Small-Cap Index Fund ETF and iShares Core S&P Small-Cap ETF ( IJR ) as investors increasingly bet that the market rally is broadening beyond mega-cap technology stocks.

However, MarketWatch reported that according to the institute, the recent momentum in small caps appeared disconnected from weakening underlying fundamentals, including deteriorating earnings expectations, lower profitability and elevated debt burdens.

The warning arrives at a time when ETF flows suggest investors are becoming more selective within the small-cap space rather than broadly embracing the rally.

While the broad-market IWM has suffered more than $8 billion in net outflows so far this year, the more quality-focused IJR has attracted roughly $2 billion in inflows, signaling that investors may be gravitating toward profitable small-cap companies instead of speculative broad-beta exposure.

Earnings Weakness Creates Pressure For Broad Small-Cap ETFs

According to the institute, consensus earnings forecasts for Russell 2000 companies have declined 7% so far this year through May 18, while earnings estimates for S&P 500 companies have risen 8%.

That divergence has become increasingly visible at the ETF level as well.

According to Dow Jones Market Data, earnings-per-share estimates tied to IWM have weakened sharply during 2026, while estimates linked to large-cap funds such as IVV and SPY have continued moving higher.

The combination of falling earnings expectations and rising prices has also increased valuation concerns for some small-cap ETFs, since weaker earnings mechanically inflate price-to-earnings ratios.

Nearly 40% of companies in the Russell 2000 currently do not generate earnings, up from roughly 17% two decades ago.

The institute attributed part of that shift to the rapid growth of private capital markets, which have allowed stronger companies to remain private longer, while mergers and acquisitions have steadily removed profitable businesses from the public small-cap universe.

That dynamic has increasingly left broad small-cap indexes populated by younger, less profitable and more speculative companies.

Quality Divide Emerges Inside Small-Cap ETFs

The changing makeup of the small-cap market is also widening the gap between broad-market and quality-focused ETFs.

Unlike the Russell 2000, the S&P SmallCap 600 index tracked by IJR and SPDR S&P 600 Small Cap ETF (SLY) applies profitability screens to constituents, creating a relatively higher-quality portfolio.

Other quality-oriented small-cap funds such as Pacer US Small Cap Cash Cows ETF and Avantis US Small Cap Value ETF ( AVUV ) have also remained in focus as investors look for stronger balance sheets and more durable earnings exposure within the asset class.

The trend mirrors broader ETF flow patterns this year. While SPY has recorded more than $7 billion in net redemptions year-to-date, investors have continued adding money to growth-focused funds such as QQQ, which has attracted nearly $3 billion in inflows.

The divergence suggests investors are becoming increasingly selective about where they seek equity exposure rather than simply rotating wholesale into riskier market segments.

Debt Burdens Add Another Layer Of Risk

There is also a substantial profitability and leverage gap between small-cap and large-cap companies.

Small-cap firms generated return on equity of less than 1% over the trailing 12 months through the first quarter of 2026, compared with roughly 20% for large-cap companies, according to the note.

Net profit margins for small caps stood near 4.4%, versus roughly 14.5% to 14.8% for large-cap firms.

At the same time, small-cap companies carried average net debt-to-EBITDA ratios near 4.5 times, compared with approximately 1.5 times for large caps.

With interest rates remaining elevated, the institute said heavily indebted smaller companies could face reduced flexibility to refinance debt or raise fresh capital if economic conditions weaken.

That may leave investors increasingly focused on higher-quality small-cap ETFs even as enthusiasm around the broader small-cap rally continues building.