Reassessing Small-Cap Value Opportunities Amid AI-Driven Market Extremes

The relentless surge of AI-driven growth stocks has reshaped market dynamics in 2025, creating a stark divide between high-flying tech darlings and underperforming sectors. Amid this backdrop, the Virtus KAR Small-Cap Value Fund (KAR Small-Cap Value) has carved a distinct niche by prioritizing high-quality, low-volatility companies with durable economic moats. This strategy, which emphasizes economically sensitive industries and disciplined capital allocation, offers a compelling counterbalance to the frothy optimism surrounding generative AI and its macroeconomic implications.

Strategic Positioning: Quality Over Hype

The KAR Small-Cap Value Fund's portfolio is anchored in companies with strong balance sheets, consistent earnings, and market-dominant business models. As of September 30, 2025, the fund's average weighted market cap stood at $6.38 billion, with top holdings including Construction Partners Inc and Armstrong World Industries Inc. These companies exemplify the fund's focus on sectors such as industrials and construction, which have historically demonstrated resilience during economic transitions. For instance, Construction Partners, a road resurfacing specialist, has benefited from infrastructure spending tied to AI-driven logistics and transportation innovations. Similarly, Armstrong World Industries, a leader in commercial sealing manufacturing, has seen demand surge as AI adoption drives modernization in industrial infrastructure.

This approach contrasts sharply with the volatility of AI-centric growth stocks, which often trade at speculative valuations. According to the fund's Q2 2025 commentary, growing uncertainty around tariffs has led many companies to scale back capital expenditures, yet KAR's portfolio has maintained steady performance by focusing on firms with predictable cash flows and low business risk.

Navigating AI-Driven Market Extremes

While the Magnificent Seven tech stocks have dominated market headlines, their influence has created imbalances in risk-return profiles. The KAR Small-Cap Value Fund's portfolio manager, Julie Kutasov, noted in the 3Q25 Portfolio Review that small and mid-sized companies have outperformed expectations in earnings growth, despite macroeconomic headwinds. This underscores the fund's ability to identify undervalued opportunities in sectors like industrials and cyclicals, which have faced pressure from AI-driven capital reallocation but remain fundamentally strong.

However, the fund's strategy is not without challenges. Consumer staples and discretionary sectors, which are sensitive to shifting spending patterns, have underperformed. Companies like Prestige Consumer Healthcare and Cheesecake Factory, previously held by the fund, saw declines due to near-term uncertainties around AI's impact on labor markets and consumer behavior. These risks highlight the importance of active management in balancing exposure to economically sensitive sectors while avoiding overreach into speculative AI plays.

The KAR Small-Cap Value Fund's low-volatility approach is particularly relevant in an era where AI hype has inflated valuations across the board. By prioritizing companies with durable competitive advantages-such as Armstrong World Industries' proprietary sealing technologies or Houlihan Lokey Inc's expertise in mergers and acquisitions-the fund mitigates downside risk while capturing growth from AI-related infrastructure spending. According to the fund's product page, this dual focus on quality and economic sensitivity aligns with broader macroeconomic trends, including the need for physical infrastructure to support AI-driven digital ecosystems.

Critically, the fund's underperformance relative to the Russell 2000® Value Index in Q2 2025 (3.81% vs. 4.97%) reflects the broader struggles of value strategies in a growth-obsessed market. Yet, as Kutasov emphasized, current valuations in industrials and cyclicals appear attractive, suggesting that the fund's disciplined approach may yield stronger risk-adjusted returns over the long term.

Conclusion

In a market increasingly dominated by AI-driven narratives, the Virtus KAR Small-Cap Value Fund offers a refreshing counterpoint. By targeting high-quality, economically sensitive companies with low volatility, the fund addresses the limitations of speculative growth investing while capitalizing on AI's indirect infrastructure needs. While challenges such as tariff uncertainty and consumer sector fragility persist, the fund's strategic positioning in fundamentally strong sectors like industrials and construction positions it as a resilient alternative for investors seeking balance in an unbalanced market.