KAR Small-Mid Cap Growth Under Pressure in Momentum-Driven Market—Quality Tilt Loses Alpha Edge as Speculative Names Outperform

The institutional landscape in 2025 was defined by a powerful, AI-driven momentum regime that directly challenged the quality-focused strategy of the KAR Small-Mid Cap Growth fund. The year opened with a classic speculative rally in small- and mid-cap stocks, a textbook narrative-versus-fundamental story largely fueled by the broadening of the AI trade away from mega caps fueled by AI enthusiasm and a more favorable macro backdrop. This shift created pronounced headwinds for quality-focused portfolios, as investors rotated toward risk-on assets. The macro environment provided fertile ground: interest rates were coming down, lowering borrowing costs for smaller, more sensitive companies, while strong earnings growth and a surprisingly resilient consumer outlook supported the optimism interest rates are coming down, lowering borrowing costs. This combination of factors drove a significant performance divergence, with momentum strategies in the small- and mid-cap space outperforming quality meaningfully.

This momentum tailwind persisted even through periods of pronounced macro uncertainty. The fourth quarter of 2025 stands as a compelling testament to the resilience of risk assets. Despite a historic government shutdown, a spike in job cuts, and consumer sentiment near record lows, U.S. equities delivered a solid 2% return for the quarter U.S. and international equities delivered quarter-to-date returns of 2% and 5%, respectively. A balanced portfolio returned 2% for the quarter, demonstrating how the bull market climbed a wall of worry. This environment was particularly challenging for the fund, as it targets long-term capital appreciation in small- and mid-cap growth sectors while seeking to incur less risk than the broader market pursues long-term capital appreciation... while seeking to incur less risk. In a year where momentum and speculative narratives dominated, the fund's core strategy of investing in companies with sustainable competitive advantages at attractive prices was under direct pressure.

The result was a clear performance gap. While the broader market rallied, the fund's negative absolute returns reflected its underperformance in this specific regime the Strategy having negative absolute returns. The manager noted that names with negative earnings, a sizable portion of the benchmark, were the strongest performers, a dynamic that inherently disadvantages a quality tilt Names with negative earnings representing a sizable portion of the Russell 2500TM Index were the strongest performers. The takeaway for institutional allocators is that the fund's quality factor was not a source of alpha in 2025; it was a source of relative risk in a momentum-driven market.

Portfolio Construction: A Conviction Buy on Quality with a Disciplined Filter

The fund's portfolio construction is a direct application of its quality-focused philosophy, designed to deliver risk-adjusted returns in a crowded small- and mid-cap growth space. Its foundation is a strict mandate: under normal circumstances, the fund invests at least 80% of its assets in common stocks of small- and mid-market capitalization companies. This concentration ensures the strategy remains true to its core mandate while providing a clear filter against broader market drift.

The selection process itself is a multi-layered discipline. The fund seeks companies with durable competitive advantages, excellent management, lower financial risk, and strong growth trajectories. This isn't a vague appeal to "quality"; it's a concrete set of criteria. The manager looks for businesses that are differentiated by above-average returns on capital, a key indicator of economic moat. The process also emphasizes solid balance sheets, consistent growth, profitability, and market dominant business models, all of which contribute to lower earnings variability and a stronger ability to protect profits during downturns.

This disciplined filter manifests in portfolio characteristics. The strategy favors a limited number of investments, typically 20 to 35 of the portfolio team's strongest ideas. This concentrated approach, paired with a long-term, low-turnover approach, is intended to realize the full value potential of each conviction buy. The result is a portfolio that is inherently less susceptible to idiosyncratic risk from any single holding, though it remains exposed to the broader risks of the small- and mid-cap growth style.

The bottom line is a portfolio built on a clear, repeatable framework. It defines quality through a combination of financial strength, competitive positioning, and growth sustainability, then applies a rigorous valuation check. This disciplined assessment of above-average returns on capital and attractive prices is the engine that drives the fund's attempt to generate superior risk-adjusted returns, even when the broader market is chasing momentum.

Performance and Risk-Adjusted Returns: Measuring the Quality Premium

The fund's actual returns reveal a clear performance gap in 2025, starkly contrasting its long-term risk-adjusted return objective. For the Class I share class, the numbers show a strong finish to 2024 but a difficult year ahead. The fund delivered a 4Q24 return of 6.12% and a YTD return of 31.71% as of December 31, 2024. This positioned it well against its benchmark at the close of the prior year. However, the 2025 environment proved fundamentally hostile to its quality tilt. The manager explicitly noted that the strategy posted negative absolute returns for the year, a direct consequence of the market's rotation toward momentum and speculative narratives.

This divergence is best illustrated by the portfolio's key detractors. In 2025, quality names that were central to the fund's philosophy became significant underperformers. Charles River Laboratories and Pool Corporation were highlighted as examples of such holdings. Their struggles underscore the core tension: when the market rewards companies with negative earnings and speculative growth stories, a portfolio built on durable competitive advantages and strong financials is structurally disadvantaged. The fund's objective-to generate attractive long-term risk-adjusted returns by focusing on alpha and managing portfolio volatility-is a long-term thesis. In the short term, however, it meant accepting relative underperformance as the price of maintaining a disciplined, lower-risk profile.

The bottom line is that the fund's risk-adjusted return story in 2025 was one of controlled downside in a volatile regime, but at the cost of absolute returns. Its concentrated, quality-focused portfolio was built to protect profits and deliver superior returns over full market cycles. The 2025 results show that in a momentum-driven market, that quality premium does not materialize as alpha; it can instead represent a source of relative risk. For institutional allocators, the performance data confirms the fund's structural positioning: it is a conviction buy on quality, but one that requires patience and a long-term horizon to realize its full risk-adjusted potential.

Forward-Looking Implications: Sector Rotation and Capital Allocation

The institutional case for the KAR Small-Mid Cap Growth fund now hinges on a critical pivot: the sustainability of the AI-driven growth narrative and the market's willingness to reward capital discipline over speculative momentum. The fund's quality tilt, which underperformed in 2025, could re-emerge as a source of alpha if the current regime shifts. The key risk remains the continued outperformance of speculative momentum over quality, a dynamic that directly pressured relative returns last year. For the fund's thesis to validate, institutional investors must monitor whether the market's focus returns to earnings sustainability and capital efficiency.

The fund's success is intrinsically linked to the capital expenditure plans of its selected companies. The strategy targets businesses with durable competitive advantages and strong growth trajectories, which require significant, productive investment to maintain their edge durable competitive advantages, excellent management, lower financial risk, and strong growth trajectories. As highlighted in the broader market, technology stocks, particularly AI-related names, remained in the spotlight for the scale of their capital expenditures much market attention on the rally's sustainability and the scale of capital expenditures. The fund's portfolio must contain companies that can successfully deploy capital to drive future growth, turning today's investment into tomorrow's earnings power. If AI spending leads to overcapacity or diminished returns, the quality premium the fund seeks will be challenged.

From a portfolio construction standpoint, institutional investors should scrutinize the fund's turnover and concentration metrics to assess its alignment with a pure quality factor tilt. A high-turnover strategy would undermine the fund's long-term, low-turnover approach, which is designed to realize the full value potential of each conviction buy long-term, low-turnover approach. The fund's concentrated portfolio of 20 to 35 holdings is a deliberate filter against style drift, but it also concentrates risk. The bottom line for capital allocation is that this is a conviction play on quality, not a tactical sector rotation bet. Its performance will be measured over full market cycles, not quarterly momentum swings. For allocators, the setup calls for patience and a focus on the quality factor's long-term risk premium, while remaining vigilant for signs that the speculative momentum regime may persist.