For most of this year, investors have flocked into small caps to diversify away from the concentrated AI trade. Rising interest rates are threatening to put a damper on that. The Russell 2000 Index has already narrowed its lead over the S&P 500 this year from 11 percentage points in June to just 2 percentage points this week. Now, with the market pricing in more hikes and worries growing that the process of taming inflation will be painful, the path forward is looking fragile for small-cap companies already saddled with the reputation of being among the riskiest groups of stocks.

The shift signals growing caution among investors who previously viewed small caps as a safe diversifier. Higher borrowing costs weigh directly on smaller companies with greater debt exposure.

Market participants are now reassessing allocations as the Federal Reserve's inflation-fighting path remains uncertain and potentially disruptive for leveraged equity segments.