Right Now, Small Caps May Benefit From a Stock Picking Approach

Stock selection is becoming increasingly important for those looking to gain exposure to small-cap companies. Rob Harvey, who manages the Dimensional U.S. Small Cap ETF, takes an actively managed approach when investing in small-cap stocks, aiming to avoid those that are underperforming and dragging down the index. His goal is to focus on more profitable small-cap companies and enhance returns by avoiding those that “scrape the bottom of the barrel,” as he explained during an appearance on CNBC’s “ETF Edge.”

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Harvey emphasized that eliminating poorly performing companies from a small-cap portfolio can significantly improve returns. His strategy seeks to identify small-cap stocks that show more promise, rather than holding onto those that are barely profitable or underperforming. By doing so, the ETF aims to deliver better performance compared to the overall index of small caps, which often includes a mix of winners and losers.

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The small-cap sector, as measured by the Russell 2000 index, has performed well in 2024, gaining more than 12% so far this year. However, the broader S&P 500, which tracks large-cap stocks, has outpaced small caps, rising about 23% over the same period. This disparity reflects the more pronounced volatility and varying performance that is typical within the small-cap space, where companies often face greater challenges but also present more growth opportunities.

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Harvey’s Dimensional U.S. Small Cap ETF holds several well-known companies, with top holdings including Sprouts Farmers Market, Abercrombie & Fitch, and Fabrinet. Interestingly, the largest single holding in the fund, accounting for 1.13% of the portfolio, is actually cash and cash equivalents. This allocation to cash can be a reflection of the active management strategy, allowing the fund to maintain liquidity and be ready to capitalize on opportunities or avoid risks within the volatile small-cap space.

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Ben Slavin, the global head of ETFs for BNY Mellon, noted that investor interest in actively managed products, especially within the small-cap sector, is growing. Investors are increasingly seeking strategies that help screen out underperforming companies, which may have a significant impact on a portfolio’s overall performance. According to Slavin, the shift in investor sentiment towards small-cap stocks is evident in fund flows, with more dollars being allocated to products that actively manage small-cap exposure.

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He also pointed out that investors are looking for strategies that differentiate between strong and weak companies within the small-cap universe. In recent months, the influx of investor capital into small-cap ETFs with active management reflects this growing desire for products that filter out the laggards, allowing for a more concentrated focus on companies with higher growth potential.

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Despite the active approach taken by the Dimensional U.S. Small Cap ETF, the fund has slightly underperformed the Russell 2000 so far this year, trailing the index by more than one percentage point as of Friday’s close. While the Russell 2000 has gained over 12%, the Dimensional U.S. Small Cap ETF has lagged behind, although the active management strategy aims to position the fund for stronger performance over the long term by focusing on higher-quality companies.

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Investors who focus on small caps often look for stocks that can offer greater growth potential compared to large-cap stocks. However, the small-cap space is also known for its higher risks, with many companies facing challenges related to profitability, market volatility, and operational inefficiencies. Active management within small-cap ETFs, such as the strategy employed by Harvey, seeks to mitigate some of these risks by carefully selecting companies that are better positioned to succeed.

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In terms of strategy, actively managed small-cap ETFs stand apart from their passively managed counterparts, such as those that simply track an index like the Russell 2000. Passive strategies typically aim to match the performance of the index, holding all or most of the stocks within it, regardless of the individual performance of each stock. This can result in exposure to underperforming companies, which may drag down returns. By contrast, actively managed funds seek to identify and invest only in the companies that show stronger financials and better growth potential, which can provide higher returns over time.

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The Dimensional U.S. Small Cap ETF’s focus on active management reflects a broader trend within the ETF market, where investors are increasingly looking for strategies that can offer an edge over traditional index funds. This is particularly true in sectors like small caps, where volatility and company-specific risks are more pronounced. The active approach allows fund managers to avoid companies that are struggling and instead focus on those with stronger fundamentals and greater potential for growth.

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As small caps continue to attract investor interest, it’s clear that active management could play a key role in driving performance in this sector. While the Dimensional U.S. Small Cap ETF has slightly underperformed the Russell 2000 this year, its strategy of avoiding poorly performing companies and focusing on higher-quality small caps may position it well for long-term success. Investors seeking exposure to small-cap stocks may find that active management offers an advantage in navigating the complexities and risks of this dynamic market segment.

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