Active Management in U.S. Small-Cap Equities: Performance and Sector Allocation Insights

The debate between active and passive management has long dominated investment discourse, but in the U.S. small-cap equity space, active strategies have shown a distinct edge in recent years. According to a report by Morningstar, active small-cap managers achieved a 43% success rate in 2024, outperforming their mid- and large-cap counterparts, which lagged at 37% [1]. This trend, while not universal, underscores the unique dynamics of the small-cap market—a realm where inefficiencies and dispersion create fertile ground for skilled managers to capitalize on mispriced securities [2].

Performance Differentiation: A Nuanced Landscape

The small-cap segment’s inherent inefficiencies stem from lower analyst coverage, higher liquidity risks, and a broader range of company fundamentals. These factors contribute to significant performance dispersion, as evidenced by the Morningstar Active/Passive Barometer, which notes that nearly 38% of active small-cap funds outperformed passive benchmarks over the past decade [1]. In Q1 2025, active small-cap core and growth managers delivered aggregate outperformance of 1.49% and 0.48%, respectively, according to Envestnet | PMC [2]. However, this success was uneven: small-cap value strategies underperformed by 0.43%, highlighting the importance of strategic sector allocation.

Structural challenges, such as small-cap stocks’ sensitivity to interest rates and their limited exposure to high-growth technology sectors, have historically hindered their performance against large caps. Yet, as macroeconomic conditions improve and valuations become attractive, the tide appears to be turning. The Russell 2000’s current valuation levels resemble those of 1998–1999, a period preceding a 13-year outperformance cycle [3]. This suggests that active managers, with their ability to navigate volatility and adapt to shifting market conditions, may be well-positioned to capitalize on an impending reversal.

Sector Allocation: The Active Edge

Sector rotation has emerged as a critical differentiator for active small-cap funds. For instance, the Kennedy Capital Management Small/Mid Cap Core portfolio in Q2 2025 overweighted Industrials and Information Technology, sectors that surged amid a market rotation away from large-cap tech stocks [4]. Conversely, underweights in Financials and Real Estate mitigated losses as these sectors faltered. Similarly, the Heartland Small Cap Value Strategy gained 14.63% in Q2 2025, outperforming the Russell 2000® Value Index by leveraging undervalued opportunities in defensive sectors [5].

Active managers also demonstrate a quality bias, avoiding unprofitable companies that often drag down passive benchmarks. Vanguard research reveals that 18% of active small-cap blend funds outperformed their benchmarks over the trailing 10 years, compared to just 5.8% of large-cap blend funds [6]. This quality focus was evident in the KCM Small Cap Growth fund, which outperformed the Russell 2000® Growth Index by 226 basis points in Q2 2025, driven by strong performers in Communications Services and Health Care [7].

However, sector-specific risks persist. The Materials and Energy sectors, for example, underperformed in Q2 2025 due to supply overhangs and integration challenges [4]. Active managers must balance sector exposure with macroeconomic signals, such as the anticipated impact of Fed rate cuts and trade policy shifts, to optimize returns.

Challenges and Considerations

Despite these advantages, active management in small-cap equities is not without drawbacks. Higher fees and the need for specialized expertise remain barriers, particularly for investors seeking cost efficiency. Additionally, the success of active strategies hinges on manager skill and market conditions, as evidenced by the SPIVA U.S. Mid-Year 2025 report, which noted that 22% of small-cap active funds underperformed benchmarks by mid-year [8].

Yet, the case for active management strengthens in an environment marked by market concentration and structural shifts. The dominance of large-cap tech stocks has created a fertile backdrop for active managers to diversify capital flows into smaller, high-quality companies [3]. Furthermore, advancements in AI and machine learning are enhancing active strategies by improving risk modeling and portfolio construction [9].

Conclusion

As the U.S. small-cap market navigates a potential inflection point, active management offers a compelling case for investors seeking differentiated returns. By leveraging sector rotation, quality bias, and adaptability to macroeconomic cycles, active managers can exploit inefficiencies that passive strategies are constrained to address. While challenges persist, the combination of attractive valuations, improving economic conditions, and technological innovation positions active small-cap equities as a strategic asset class for forward-looking portfolios.

Source:
[1] Active vs. Passive Funds: Performance, Fund Flows, Fees [https://www.morningstar.com/business/insights/blog/funds/active-vs-passive-investing]
[2] Analyzing Q1 2025 active and passive asset classes [https://www.envestnet.com/financial-intel/analyzing-q1-2025-active-and-passive-asset-classes]
[3] Small Caps vs. Large Caps: The Cycle That's About to Turn [https://blogs.cfainstitute.org/investor/2025/04/24/small-caps-vs-large-caps-the-cycle-thats-about-to-turn]
[4] Small Cap Select – Q2 2025 Commentary [https://www.kennedycapital.com/small-cap-select-comm-q2-2025/]
[5] Heartland Small Cap Value Strategy Q2 2025 Commentary [https://seekingalpha.com/article/4805053-heartland-small-cap-value-strategy-q2-2025-commentary]
[6] Market Perspectives - Vanguard Advisors [https://advisors.vanguard.com/insights/article/series/market-perspectives]
[7] Small Cap Growth – Q2 2025 Commentary [https://www.kennedycapital.com/small-cap-growth-comm-q2-2025/]
[8] SPIVA Mid-Year Report Focuses on Active SMIDcap Funds [https://www.etftrends.com/spiva-2025-mid-year-report-throws-spotlight-active-smidcap-funds/]
[9] Asset Management Trends 2025 [https://www.empaxis.com/blog/asset-management-trends]