The small-cap market, often considered a high-risk, high-reward segment of the stock market, is currently experiencing a surge of interest. However, actively managed strategies focused on selecting high-performing stocks within this sector are demonstrating significant outperformance compared to passively managed index funds. This shift highlights a growing trend amongst investors seeking to mitigate risk and maximize returns in the volatile small-cap space. The success of active management in this sector underscores the importance of stock picking expertise and strategic portfolio construction, especially within a market segment known for its high degree of variability.

Active Management Takes the Lead in Small-Cap Investing

The Rise of Active Management in Small-Cap Investing

The small-cap market, characterized by companies with relatively small market capitalizations, has historically been known for its volatility and higher risk profile. Traditionally, investors seeking exposure to this sector often relied on passively managed index funds like the Russell 2000, which simply tracks the performance of a broader index of small-cap companies. However, a growing number of investors now believe that an active approach might yield better results.

Why Actively Managed Strategies Are Winning

The core argument for the recent outperformance of active strategies centers on the ability of skilled fund managers to identify and invest in high-growth, high-potential small-cap companies while simultaneously avoiding those demonstrating signs of underperformance or financial distress. Rob Harvey, co-head of product specialists at Dimensional Fund Advisors (DFA), emphasizes this point: “There’s no reason to hold companies that really are scraping the bottom of the barrel in terms of profitability. You remove those from your small cap universe, [and] you can do a lot for boosting returns.” This active selection process aims to optimize portfolio performance by focusing on fundamentally strong companies with a higher probability of growth.

Benchmarking Performance: DFAS vs. the Russell 2000

The Dimensional U.S. Small Cap ETF (DFAS) serves as a compelling case study. While it employs an active management strategy, targeting high-performing small-cap companies and excluding weaker ones, its year-to-date performance shows a slightly different picture. Despite actively avoiding underperformers, as of late October 2024, DFAS is slightly underperforming the Russell 2000, which has seen returns exceeding 12%. This nuance highlights the fact that even actively managed funds face market fluctuations and don’t guarantee consistent outperformance in every market cycle. However, the long-term strategy may prove more stable. This underscores the complex nature of market dynamics and emphasizes that past performance is not necessarily indicative of future results. However, the underlying premise remains – thoughtful stock selection, especially in sectors like smaller caps, can have great value.

Investor Sentiment and Market Flows

The shift towards actively managed small-cap strategies isn’t just a reflection of fund manager expertise; it is also influenced by a broader change in investor sentiment and market dynamics. Ben Slavin, global head of ETFs for BNY Mellon, notes a significant increase in investor interest in small-cap stocks, stating, “Investor sentiment has shifted towards small caps, and you see that in the numbers, in terms of where investors are putting their dollars, from a flow standpoint. These types of strategies are benefitting.” This influx of capital into the small-cap space further fuels the demand for sophisticated investment strategies capable of navigating the volatility and identifying opportunities within this dynamic sector.

The Role of Cash in Active Small-Cap Management

Interestingly, a review of DFAS holdings reveals an unexpected top position: cash and cash equivalents, comprising 1.13% of the fund as of a recent reporting period. The inclusion of a significant cash position is not typical in actively managed equity funds, and demonstrates that managers must be willing to wait and be ready to deploy capital when the right opportunities are more visible. This approach further highlights that active management in small cap involves a more nuanced and flexible approach than simply chasing high-growth companies at all times.

The Future of Active Management in Small-Caps

The current trend toward active management in small-cap investing isn’t simply a fad. It’s a reflection of evolving preferences and strategies in the investment landscape. Active management’s ability to address the potential risks associated with high-volatility small-cap stocks, through strategic stock selection and risk mitigation, looks to be a significant factor driving its growing popularity. Future performance will depend on a number of market cycles, but the current data shows the underlying approach has real market value.

Considering Risk and Reward

While actively managed strategies have demonstrated promising results, investors must remember that no investment strategy guarantees returns in a volatile market. The small-cap market remains inherently risky. Due diligence, diversification, and a long-term outlook are crucial considerations in any small-cap investment strategy, regardless of whether it is actively or passively managed.

The success of actively managed funds like DFAS, while notable, doesn’t represent a universal guarantee of returns. Instead it points towards a growing demand for more sophisticated and strategic approach to managing risk and capital allocation within the often-turbulent waters of the small-cap market. This is a long game, and investors who appreciate that fact can appreciate the current successes.

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