A couple weeks ago, we examined the risk-return profile of the S&P 500 by analyzing its Sharpe Ratio (SR) historically and throughout 2025 (read more here). In this week’s piece, we’re building on that discussion by extending the analysis to small cap and mid cap equities. Our goal is to understand how their risk-adjusted performance has evolved and what these shifts might imply for investors.

A Quick Refresher on the Sharpe Ratio

The Sharpe Ratio is a widely used metric for evaluating risk-adjusted returns. It is calculated in four steps:

     1. Subtract the daily risk-free rate (approximated by the Treasury yield) from the asset’s daily return to obtain excess returns.

     2. Compute the standard deviation of those excess returns.

     3. Divide the average excess return by its standard deviation.

     4. Annualize the ratio to represent one-year (252 trading days)

While the formula is simple, the challenge lies in selecting an appropriate time frame. For consistency with our previous analysis, we applied a 6-month rolling Sharpe Ratio and then smoothed the data using a 30-period simple moving average (SMA) of the Sharpe Ratio. For today’s discussion, we focus exclusively on 2025—a year characterized by sharp swings in both returns and volatility.

Sharpe Ratio Trends for Small-Caps and Mid-Caps

The chart below illustrates SR trends for the iShares Russell 2000 ETF(IWM) and iShares S&P MidCap 400 Index Fund (IJH) throughout the year:

Early 2025: Both groups began with SRs near 1.0 but slipped into negative territory between mid-March and late August, reflecting deteriorating risk-adjusted performance during that period.

Recovery Phase: In early September, SRs turned positive and trended higher, signaling improving conditions for both groups.

Late Year: After peaking in late November, SRs began to decline again. However, December showed a modest rebound, suggesting a potential reversal in the trend.

Key Observations

One notable takeaway is that small-caps consistently outperformed mid-caps on a risk-adjusted basis during the second half of 2025. The SR for IWM peaked around 2.25, compared to roughly 1.5 for IJH. In addition, both groups maintain actionable fund scores above 4.0, but IWM holds a slight edge with a score approximately 0.25 higher than IJH, making small caps a relatively more attractive opportunity.

The iShares Russel 2000 ETF (IWM) completed a double top break at $255 earlier this month, marking the fund second consecutive buy signal and a new all-time high for the ETF. IWM maintains a strong fund score of 4.34, with a notable score direction of 3.19, demonstrating the improvement in the fund within the last few months. Additionally, IWM reversed back into Xs against the market in September, further helping improve the score for the fund. Long exposure can be made here. Initial support is at $230, with additional support at $182

With 2025 nearing a close quarterly and year-end reports are soon to follow as investors look toward 2026. Among the many tools that will be covered in the coming weeks, today’s piece will focus on NDW’s Dynamic Asset Level Investing (DALI) Tool. As a brief reminder, the tool utilizes relative strength to rank asset and sub-asset classes in order to identify leadership among and within asset classes. This allows investors to adapt to market trends and tactically outweigh those asset and sub-asset classes showing leadership, while avoiding laggard trends that can drag on a portfolio.

For all of 2025, DALI favored offensive asset classes with domestic and international equities maintaining the top two positions for much of the year with commodities adding to the offensive tilt of the tool. While domestic equities maintained the top spot for most of 2025, action in Q1 and Q2 brought the three offensive asset classes to a jockeying position with commodities and international equities each spending time as the top ranked asset class during Q2. Defensive asset classes like cash, currencies, and fixed income maintained their rankings in the fourth, fifth, and sixth positions all year long with brief improvement in Q2 providing ultimately giving way to the rebound from offensive assets in the back half of the year.

The sections below will cover action in sub-asset classes within the following broader assets – domestic and international equities, commodities, and fixed income.

Domestic Equities - Sectors

After beginning 2025 with financials as the top sector, communication services and technology ultimately maintained the top two spots for most of the year, highlighting the broad technology and large cap theme remaining prevalent for a third year in a row. Industrials marked another year ranking in the top half of the DALI sector rankings, a trend that began in June 2022. Financials, consumer discretionary, and utilities were the sectors in 2025 that saw the most ranking changes with discretionary and utilities falling out of the top half of the sector rankings in the back-half of the year, while financials fell from first to fifth by year end. The sector with the most consistent improvement in 2025 was basic materials. Along with improvement in the Q4 from healthcare and energy, basic materials provided a boost for small cap stocks in the latter part of 2025. As investors enter 2026, sector leadership continues to maintain within offensive areas, but the relative gain within defensive sectors like basic materials, healthcare, and energy have the team monitoring the rankings closely.

International Equities

Leadership within international equities has maintained within the European region throughout 2025 with emerging countries sustaining the leadership baton. Consistent improvement within Latin America brought the region from the doldrums of the international rankings to the second position. Latin America’s improvement brought about relative deterioration within developed Europe and emerging Asia. While China remains one of the bright spots within emerging Asia, leadership out of emerging Europe and Latin America shows the broader international space favors emerging markets entering 2026. While lagging somewhat to emerging markets entering 2026, developed markets continue to show positive relative strength against broader commodities, fixed income, cash and currencies, along with segments of domestic equities. This highlights the broader strength by international equities shown in the asset class rankings above.

Commodities

Apart from a brief period in Q1, precious metals were the dominant theme within broader commodities throughout 2025 as the likes of gold and silver rallied to highs and had their best year in decades. Agriculture took the brunt of showing relative weakness as it fell to the last spot after beginning the year near the top of the commodity rankings. Energy weakness relative to other commodities have garnered attention in the back half of the year, which has led to a notable gap between relative leaders precious and industrial metals as 2026 begins.

Fixed Income

Leadership within fixed income remained within the U.S. high yield space throughout 2025. Areas that showed relative improvement against their fixed income counterparts in 2025 were U.S. corporate debt, long duration U.S. treasuries, and inflation protected debt. After seeing improvement in the first half of the year, international debt and short duration U.S. treasuries fell out of favor in the back half of the year. U.S. preferreds & convertibles along with municipal bonds were the notable areas of relative deterioration throughout 2025 and now rank in the bottom half of the fixed income rankings. Superior relative strength resides within the higher yield areas of the broader fixed income space as investors enter 2026.

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