Why Consider Active Management Over Index Funds for Small Cap Stocks in 2025

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. 

Not All Indexes are Created Equal 

In contrast to the Russell 2000, the S&P 600 index takes a different approach by incorporating a profitability screen, effectively excluding companies that don’t meet certain earnings criteria. Perhaps it’s no coincidence that the S&P 600 has handily outperformed the Russell 2000 over the past decade, highlighting the impact of filtering out non-earners in small cap investing. 

Navigating the 2025 Landscape 

Looking forward, the economic and regulatory environment poses unique challenges for small cap companies. A new political administration will introduce new opportunities for small US companies, but risks abound with tariff policy, elevated interest rates, continued inflation, and regulatory changes. 

Rising interest rates make borrowing more costly, which disproportionately impacts smaller companies, as they often rely more heavily on debt to finance growth. Additionally, smaller firms may be worse equipped than large companies to navigate regulatory changes.  

Active managers may be able to navigate these changes strategically, identifying companies that are not only profitable but also better positioned to adapt to a new environment. 

Glassman Pro Tip: Consider Active Management as a Value-Add in Small Caps 

While index funds remain a great choice in many investment scenarios, small cap stocks stand out as an area where active management could be a better choice. As always, consult your financial advisory team to tailor strategies that align with your individual financial goals and risk tolerance.