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Portfolio construction

Small-cap equity and the case for active management

June 13, 2024 - 8 min read

Small-cap equities are garnering increased attention from investors, and for good reason. Small-caps are trading at historically cheap valuations relative to large-caps, amid a backdrop of robust US economic growth and expectations of earnings reacceleration. This is typically a recipe for small-cap equity outperformance. 

However, significant developments have reshaped the landscape of small-cap investing, making the implementation of a small-cap allocation less straightforward today. Investors have generally been flocking to passively managed strategies, which track a broad-based index, but doing so in the small-cap space looks to be a suboptimal approach. There are several reasons why.


Declining exposure to growth businesses in the small-cap index

The S&P SmallCap 600® index offers less exposure to innovative, growth-oriented companies than it has historically. Analyzing sector allocations of the S&P 600® reveals a noteworthy trend: a surge in cyclical sectors coupled with a decline in growth sectors over the past 20 years (Figure 1). This is how we define these sector groupings:

  • Cyclical sectors – higher earnings sensitivity to the economic growth: Financials, Industrials, Materials, Energy, and Real Estate.
  • Growth sectors – higher long-term growth rates due to their products and services being tied to innovative technology and secular trends: Information Technology, Communication Services, and Consumer Discretionary.


Figure 1 – S&P 600® Index: Cyclicals vs. Growth Sectors (1/2004–3/2024)
Figure 1 – S&P 600® Index: Cyclicals vs. Growth Stocks (1/2004-3/2024) Chart

Source: Morningstar Direct


Earnings growth expectations declining

This change in sector makeup has certainly had an impact on earnings growth expectations for the index. Figure 2 shows that analyst expectations for long-term earnings growth (sustainable 3–5 year rate) for S&P 600® companies have steadily decreased over the past 20 years. Aside from the spike during 2020/2021 (Covid), the long-term expected growth rate has decreased from the mid-teens in 2004 to high single digits in 2024.


Figure 2 – Expectations for Long-Term Growth (5/2004–4/2024)
Figure 2 – Expectations for Long-Term Growth (5/2004-4/2024) Chart

Source: FactSet


The delayed entry of innovative, growth-oriented companies into public markets is likely the key driver of the changing makeup of the small-cap index. Access to private funding has grown considerably over the past few decades, so companies are better able to scale their business without needing to turn to public markets. The average age of a new public company has gone from 4.5 years in 1999 to roughly 12 years today, and the small-cap index misses out on a significant portion of high-growth businesses, particularly in the technology sector. 


Private equity and unicorns

Figure 3 shows the sector breakout of two of the largest segments of the private equity space – Buyout and Venture Capital. If you assume the average of these two segments is a reasonable representation of the private equity landscape, roughly 60% of this space is made up of technology companies. Many of these companies are able to scale their business to substantial valuations. This has brought on the rise of “unicorns” – private companies that have reached a $1 billion valuation. Figure 4 shows the growth in number and total valuation of these unicorns over the past six years.


Figure 3 – Buyout and Venture Capital Sector Breakouts as of 6/30/23
Figure 3 – Buyout and Venture Capital Sector Breakouts as of 6/30/23 Charts

Source: Refinitiv,


Figure 4 – Number and Value of Unicorns Is Growing (6/2018–3/2024)
Figure 4 – Number and Value of Unicorns Is Growing (6/2018-3/2024) Chart

Source: CB Insights,


Additionally, the small-cap index has seen its exposure to low-quality companies increase over time – a function of companies staying private longer. This has contributed to a shrinking universe of public companies, as there are fewer IPOs, and at the same time, stronger public companies are being acquired. The public US equity universe peaked in the late 1990s at roughly 8,000 companies. Fast-forward to today, that number is less than 4,000. 


In theory, this should decrease the quality of the remaining public constituents that make up small-cap indexes. Let’s decompose the S&P 1500® as an example. The S&P 500® is made up of the largest 500 companies, based on market capitalization in the public equity universe. The S&P 400® is made up of the next largest 400 companies, leaving the remainder for the S&P 600® index. If the remaining universe shrinks from 7,000 to 3,000, it stands to reason that the S&P 600® would see a decline in quality.


A closer look at the small-cap index

The decline in quality in small-cap indexes is well supported by the data. First, the percentage of negative earners in the S&P 600® is steadily rising. Figure 5 shows the percentage of negative earners in the S&P 600® on a trailing 12-month basis in 2014, 2019, and 2024. In 2014, the percentage of negative earners was just 13%, but by 2024, that percentage has grown to over 20%. 


Figure 5 – Percentage of Negative Earners in the S&P 600® Has Increased
Figure 5 – Percentage of Negative Earners in the S&P 600® Has Increased

Source: FactSet


Next, we used the Altman Z-Score framework to measure quality within the S&P 600® index. The Altman Z-Score is a measure of a company’s credit strength used to gauge its likelihood of bankruptcy. Figure 6 displays the five underlying components that drive the calculation. This score categorizes companies into three zones – distress, grey, and safe. When we say distress, this indicates a 90% probability of bankruptcy in the next two fiscal years. Grey indicates to proceed with caution. Safe indicates an extremely low probability of bankruptcy. 


Figure 6 – Altman Z-Score Measures Credit Strength
Figure 6 – Altman Z-Score Measures Credit Strength Chart

Source: Edward Altman. “Financial ratios, discriminant analysis and the prediction of corporate bankruptcy.” The Journal of Finance, vol. 23, no. 4, 28 Sept. 1968, p. 589,


The evolution of these Altman Z-Scores for the S&P 600® index over the past 10 years is shown in Figure 7. Since 2014, the percentage of companies in the distress and grey zones has increased meaningfully, while the percentage of companies in the safe zone has plummeted. 


Figure 7 – The Quality of Smaller Companies Is Declining
Figure 7 – The Quality of Smaller Companies Is Declining Chart

Source: FactSet


The case for active management

In summary, the case for active management within small-caps is driven by two key points. Compared to a decade ago, investing in a passively managed strategy that tracks a broad-based small-cap index provides significantly less exposure to innovative growth companies and more exposure to low-quality companies. In this environment, opting for an active manager who can capitalize on high-upside growth companies and avoid undesirable companies has become increasingly important. Actively managed small-cap fund performance supports this idea.

Figure 8 shows the trade-off between upside capture and downside capture, relative to their respective benchmarks, for actively managed small-cap blend and large-cap blend funds over the past five years. A majority of small-cap managers have a “favorable skew,” indicating that their upside capture is higher than their downside capture. Put another way, these managers have been able to reap the benefits of high-upside companies and avoid the downside of lower-quality companies. The opposite is true for large-cap blend, where a majority of funds have an “unfavorable skew.”


Figure 8 – Tradeoff Between Upside and Downside Capture
Figure 8 – Tradeoff Between Upside and Downside Capture Chart

Source: Morningstar Direct


For small-cap blend, this has translated to strong trailing relative returns as well. Figure 9 shows the percentage of active small-cap blend and large-cap blend managers that have outperformed passive options in their Morningstar categories over trailing 1-, 3-, 5-, and 10-year periods. A majority of small-cap managers have delivered outperformance over their passive counterparts. The opposite is true for large-caps, which have struggled to keep up with their passive counterparts. This underscores the distinct advantage of active management in small-cap equity investing. 


Figure 9 – Active vs. Passive: Outperformance by Small Blend as of 3/31/2024

Source: Morningstar Direct


As the capital markets have evolved, it appears the passively managed small-cap strategies haven’t been able to keep up – disappointing investors who have relied on passive, index-based investing. But as the data shows, active management can be beneficial for investors seeking to increase their exposure to smaller, faster growing companies. 

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