Active Management in Small-Cap Equities: Navigating Q3 2025 Performance Challenges

The Russell 2000's outperformance in Q3 2025 was not an isolated event but part of a broader trend. Over the past decade, U.S. small-cap stocks have returned 9.8% annually, trailing large-cap peers by 5.2 percentage points. This underperformance has been exacerbated by structural inefficiencies in active management. For instance, the Osterweis Opportunity Fund, an active small-cap fund with a gross expense ratio of 1.19%, faced headwinds in Q3 despite contractual fee waivers reducing its net expense ratio to 1.12%. Such fee differentials, while modest, compound over time and erode the value proposition of active strategies when benchmarks outperform.

Expert analyses from Q3 2025 further reinforce this narrative. A report by Dorsey Wright & Associates noted that the Russell 2000 ranked in the 75th percentile year-to-date, with most active small-cap managers underperforming by wide margins. The high dispersion of returns in small-cap markets-a double-edged sword-amplified these challenges, as managers struggled to identify winners in a landscape where a handful of high-beta stocks drove the majority of gains.

The Case for Active Management: Market Inefficiencies and Long-Term Alpha

Despite these hurdles, proponents of active small-cap management argue that the asset class's inherent inefficiencies create opportunities for skilled managers. Over 60% of small-cap capital is now in passive vehicles, yet historical data shows that active managers have generated nearly 60% cumulative alpha over three decades. This outperformance stems from factors such as lighter analyst coverage, which allows managers to uncover undervalued companies, and the prevalence of innovative or reinventing firms whose potential is not yet widely recognized.

The Thrivent Small-Mid Cap Equity ETF (TMSE), launched in 2022, exemplifies this potential. With a three-year annualized return of over 16% as of October 2025, it has attracted $600 million in assets, demonstrating that active strategies can compete when guided by experienced teams. Similarly, small-cap markets outside the U.S. have shown resilience, with developed markets (DM) ex U.S. small caps outperforming due to lower exposure to global tariffs and attractive valuations. These stocks trade at a 10% discount to mid- and large-cap peers, offering a margin of safety as international economic fundamentals improve.

Balancing Short-Term Realities with Long-Term Potential

The Q3 2025 performance gap raises critical questions about the adaptability of active managers. While passive strategies benefit from broad market rallies, active managers must navigate the dual challenges of stock selection and positioning. For example, the London Company's underperformance was partly due to its focus on high-quality, low-volatility stocks-a strategy that fared poorly during the quarter's speculative surge around potential Fed rate cuts. This underscores the need for managers to remain agile, balancing defensive positioning with the ability to capitalize on macroeconomic shifts.

However, the long-term fundamentals of small-cap equities remain robust. Despite a decade of underperformance, small-cap stocks boast higher free cash flow growth and dividend yields than large-cap counterparts. These metrics suggest a potential reversal in performance trends, particularly as market conditions normalize and investors seek higher-yielding assets.

Conclusion: A Nuanced Path Forward

The Q3 2025 results for active small-cap management are a cautionary tale, but they do not invalidate the asset class's long-term appeal. Passive strategies will continue to outperform in favorable market conditions, but active managers retain a unique edge in identifying mispriced securities and navigating structural inefficiencies. The key lies in aligning strategies with macroeconomic cycles and leveraging manager skill to capitalize on the broader dispersion of returns. As the market evolves, investors must weigh the short-term costs of active management against its potential to deliver alpha in a landscape where small-cap stocks remain fundamentally attractive.