Why Active Small-Cap Investing Has a Window Now

Small-cap stocks have trailed their large-cap peers for years. The Russell 2000 is up roughly 8% over the past 12 months. The S&P 500 has gained more than 20%. That gap has left small-cap valuations at a discount. The index trades at about 15 times forward earnings, below its 10-year average of 17, according to FactSet. For active managers, that spread is a starting point, not a conclusion.

The case for active small-cap investing rests on two shifts. First, the rate cycle is turning. The Federal Reserve is expected to cut rates in September. Small caps tend to benefit more from lower borrowing costs because they carry more floating-rate debt. Second, dispersion within the asset class is widening. The gap between the best- and worst-performing small-cap stocks this year is the widest since 2020, data from Morningstar show. When stocks move in lockstep, passive funds capture the return. When they diverge, stock-picking matters more.

Passive small-cap funds have a structural weakness. The Russell 2000 is market-cap weighted, so the largest holdings – a handful of stocks like Super Micro Computer and MicroStrategy – dominate performance. An investor buying the index gets exposure to those names whether they want it or not. Active managers can sidestep the concentration and focus on the companies where the earnings story is real.

Some portfolio managers argue the opportunity is in quality small caps with strong balance sheets. Companies that survived the rate hikes with low debt and positive free cash flow are now positioned to gain market share as smaller competitors struggle. "The survivors are the ones that managed their balance sheets well," said a small-cap fund manager at a Boston-based firm. "They have pricing power and can reinvest when others can't."

The risks are real. A recession would hit small caps harder than large caps. Earnings estimates for the Russell 2000 have been cut by 5% over the past three months, Refinitiv data show. If the economy slows further, those cuts will accelerate. Liquidity is also thinner in small caps, which means exits can be costly when everyone tries to leave at once.

Apple (AAPL) and other mega-caps have dominated headlines. The small-cap space offers a different kind of trade. The next catalyst is the September Fed meeting. If the cut comes, small caps could catch a bid. If it doesn't, the valuation discount may widen further. Either way, the dispersion is there for active managers to exploit.