As financial planners, we often tout the benefits of passive investing through index funds, but when it comes to small cap stocks, the conversation gets more nuanced. Small cap companies—typically defined as those with a market cap between $300 million and $2 billion—offer unique opportunities for growth. But these opportunities also come with distinct risks that make a compelling case for active management. Rather than purchasing an index fund whose holdings are solely based on company size, let’s dig into why active management can be a smart choice, especially given recent data and the evolving economic landscape.
The Downside of an Index Fund
The Russell 2000, a popular index for US small companies, has a major drawback: it includes a significant number of stocks with negative earnings. In fact, as of March 31, 2024, around 42% of Russell 2000 companies reported negative earnings over the past 12 months. This means nearly half of the index is composed of companies struggling to achieve profitability. When you invest in a fund tracking the Russell 2000, you’re not only buying into growing, profitable firms but also into firms that may be battling high debt levels, fluctuating revenue, and operational instability. That’s not to say that all of those stocks are bad investments, but the effect on index performance has been notable.
The Case for Profitability Screens
One of the driving forces behind active management’s edge is the ability to focus on profitable companies—an approach that has proven to enhance returns (see chart above). Over the past few years, the performance of the median profitable company in the Russell 2000 has outpaced that of the median unprofitable company. Active managers have the flexibility to focus on profitable small cap companies while avoiding the weaker, profit-challenged firms. This selectivity can potentially provide investors with a more stable and promising return profile.Active Managers Have a Decent Track Record in Small Caps
In the small cap space, active managers have demonstrated a stronger track record relative to their counterparts in the large cap segment. According to research from SpringTide Partners and Morningstar, approximately 60% of small- and micro-cap managers beat the Russell 2000 over the trailing ten years ending August 31, 2024. This contrasts with large cap funds, where it’s much more difficult for active managers to outperform their index consistently. For investors, this historical success rate suggests that small cap managers are better equipped to identify high-quality opportunities that a simple price-weighted index approach might miss.
