Small Caps Poised for a Comeback: Why Active Management Matters Now

Small caps have now underperformed their larger siblings by the longest stretch in history.

However, investors may not want to count out small caps just yet, and active management may be the key to unlocking the true potential of smaller firms. With the Fed cutting rates, some small caps — and the active managers that own them — could provide plenty of long-term gains. This is one area of the market in which active management matters.

Small-cap equities are usually defined as those with market capitalization of less than $2 billion. These smaller firms have long been top performers, beating their mid- and large-cap peers; albeit, with more volatility.

The secret is easy to understand: It’s much easier for a smaller stock to significantly grow its revenue and make a material impact to its bottom line. For example, mega-cap Apple is expected to pull in more than $400 billion in sales this year. Even a $5 billion — which is still a lot of money — increase to that amount is only a 1.25% jump. However, for a smaller firm, that would be a huge increase.

As a result, smaller-cap stocks tend to feature faster growth and, therefore, faster reevaluations to their metrics, boosting their share prices. Typically, over long stretches of time, smaller firms tend to beat larger firms. Size has emerged as a factor that investors can exploit.

However, this relationship hasn’t been holding true for quite some time. In fact, small caps have underperformed large caps for seven years straight — the longest streak of underperformance since the 1980s. The below chart from Harbor Capital shows the negative excess returns from the asset classes.

Source: Harbor Capital

The reasons for the underperformance are vast. After the Great Recession and into the COVID-19 pandemic, investors looked toward the leadership of larger firms to get them through the economic malaise.

The Fed’s path of higher rates also hasn’t helped. Smaller firms tend to be more economically sensitive, and with rates high — i.e., the Fed is trying to cool the economy — they have continued to suffer compared to less sensitive large caps. Moreover, the debt structure of the small-cap Russell 2000 Index points heavily toward floating-rate debt. In fact, according to BlackRock, nearly 30% of all debt is tied to a floating rate.This compares to just 6% of the S&P 500. ¹

However, these issues are starting to thaw. The Fed has begun cutting interest rates, and any thoughts of a recession are now in the rearview mirror. After years of lackluster performance, small caps look attractively valued — both on a historical and a relative basis — to U.S. large caps.

However, investors may not want to use a passive index like the Russell 2000 to get their small-cap exposure and play their current return to glory. This is one area where active management can have a major impact on returns.

As we’ve said before, active management works best in pockets of the market that are inefficient and lend themselves to exploitation. There are literally thousands of small caps, and digging through those stocks can be a real hassle. Secondly, a pension fund or large endowment would have a hard time buying enough shares of a small-cap firm to truly move the needle on the fund’s returns or assets. Moreover, the scarcity of shares would certainly impact price and lead to front-running, impacting returns.

For active managers willing to dig into small caps, this can mean outperformance. The below chart from Harbor Capital underscores that more than half of active small-cap managers are among the growth, value and blend styles that outperform their passive small-cap benchmarks.

Source: Harbor Capital

This is particularly important given the current state of the market and the ongoing uncertainty about the economy, the Fed’s next rate cut, the election, etc. The key is that activeness can play a big part in maneuvering around these issues for portfolios.

And active ETFs can be the best structure for this outperformance. For starters, small-cap funds tend to feature high turnover and generate a ton of capital gains for their investors. The ETF structure mitigates these gains and the taxes that come with them thanks to the creation-redemption function. ETF managers can pass through gains/taxes without affecting their shareholders. Secondly, costs for ETFs are cheaper overall, which is important given the extra research costs associated with small-cap funds. Lower costs equal a lower fee hurdle for managers to clear.

These funds were selected based on their ability to various segments of the small-cap space using active management. They are sorted by their YTD total return, which ranges from 6% to 12.8%. They have expenses between 0.25% to 0.86% and assets under management between $6M and $11B. They are currently yielding between 0% and 1.6%.

Overall, small caps could finally see their underperformance end.

Small caps are one segment of the market that can benefit from active management. The current sector’s underperformance and the outperformance of active managers is proof of that. With small caps ready to rise, active ETFs can make all the difference when it comes to long-term returns.

¹ BlackRock (September 2024). Small-cap stocks: overshadowed opportunity amid mega-cap momentum