The Sharpe Ratio is a widely used metric for evaluating risk-adjusted returns, and today, we use it to evaluate small and mid caps.
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
