Small Cap Value Fund Performance and Strategic Positioning in a Rate-Cutting Cycle

The third quarter of 2025 marked a pivotal shift in the small-cap value landscape as the Federal Reserve initiated a rate-cutting cycle, signaling a pivot from years of restrictive monetary policy. While the broader market, particularly the Russell 2000 Index, surged by over 12% during the quarter, small-cap value funds exhibited a mixed performance. This divergence highlights the challenges of navigating a market increasingly driven by speculative momentum rather than traditional value fundamentals.

Assessing Underperformance: A Tale of Two Strategies

Small-cap value funds faced headwinds in Q3 2025, with underperformance attributed to sector misalignment and stock selection. The Royce Small-Cap Deep Value Index, for instance, returned 11.6% for the quarter but trailing the Russell 2000 by 0.8%. This gap underscores the broader index's outperformance, fueled by a macro-driven "junk rally" that favored speculative names over disciplined value investing. Similarly, the Osterweis Opportunity Fund, a small-cap growth-oriented strategy, underperformed the Russell 2000 Growth Index by 7.06% due to its avoidance of high-growth, unprofitable companies-a stark contrast to the quarter's market dynamics.

Sector-specific challenges further exacerbated underperformance. The Macquarie Small Cap Value Fund, for example, lagged its benchmark due to an underweight position in healthcare and a poorly performing stake in Integer Holdings. Meanwhile, the Cooke & Bieler Small Cap Value strategy, with 27.6% exposure to industrials and 21.7% to financials, struggled as these sectors failed to deliver the expected returns. These cases illustrate how sector concentration and stock-picking discipline can amplify or mitigate the benefits of a rate-cutting environment.

Active Management Effectiveness: A Mixed Bag

The rate-cutting cycle presented both opportunities and pitfalls for active managers. While the Russell 2000 Value Index surged, many small-cap value funds failed to capitalize on the tailwinds. Data from Q3 2025 indicates that the strongest market performers were speculative companies with weak fundamentals, such as those with no earnings and high price-to-earnings ratios. The Osterweis Opportunity Fund's disciplined approach-avoiding such speculative plays-led to underperformance despite a favorable macro environment.

Active managers also grappled with shifting investor preferences. The Federated Hermes team noted a decline in large-cap allocations as advisors pivoted toward mid-cap and small-cap stocks, anticipating market broadening. However, multi-strategy hedge funds reported mixed results, with year-to-date returns ranging from 5% to 16%, reflecting the difficulty of identifying value outside dominant market themes. These findings suggest that while the rate-cutting cycle created favorable conditions for small-cap stocks, active managers struggled to differentiate themselves in a market increasingly dominated by momentum-driven investing.

Strategic Positioning: Sector Allocations and Risk Adjustments

In response to the rate-cutting cycle, small-cap value funds adjusted their strategic positioning. Portfolios leaned into sectors perceived to benefit from lower borrowing costs, such as industrials and materials, while reducing exposure to financials and communications services. The Small/Mid Cap Core portfolio, for instance, maintained an overweight in industrials, betting on aerospace supply chain growth, but missed out on high-growth sub-sectors like bitcoin mining and quantum computing.

Risk management strategies also evolved. Equity portfolios increased allocations to domestic banks and high-yield positions, aligning with expectations of a year-end rally. Fixed-income components adopted a pro-cyclical stance by shortening duration and focusing on high-yielding, actively managed holdings. These adjustments reflect a broader industry effort to hedge against volatility while capitalizing on the accommodative monetary environment.

Conclusion: Navigating the New Normal

The Q3 2025 rate-cutting cycle underscored the dual-edged nature of small-cap value investing. While lower interest rates historically favor small-cap stocks, the quarter's performance revealed the growing influence of speculative momentum and thematic investing. Funds that adhered to traditional value principles, such as the Osterweis Opportunity Fund, faced underperformance, whereas those that adapted to the market's appetite for high-growth, unprofitable companies reaped rewards.

For investors, the takeaway is clear: in a rate-cutting environment, strategic positioning and sector agility are as critical as fundamental discipline. As the Federal Reserve continues its accommodative stance, small-cap value funds must balance the allure of speculative gains with the long-term resilience of value-oriented strategies.