How active ETFs can help investors in the small- and mid-cap space

Roughly 82% of the USD 837 billion¹ small- and mid-cap exchange‑traded fund (ETF) assets is managed based on passive strategies and in line with one of three primary index providers: S&P, Russell, or the Center for Research in Security Prices (CRSP). (See “Small- and mid-cap ETF assets, by largest passive index”) However, the USD 10.7 trillion ETF market² is changing, and actively managed ETFs are quickly becoming the fastest-growing category.

At the beginning of 2023, active ETFs held only 5.3% of the market but 75% of total ETF launches.² By the end of 2024, that number increased to 8.4% of the market and 79% of total launches.² This growth hasn’t necessarily reached across all asset classes, however. Investors show that they believe active management can work in the small- and mid-cap (SMID) space, but they are dramatically underserved in the ETF structure.

In an active ETF, fund managers make decisions, based on a predetermined investment strategy, about what securities to overweight, underweight, exclude, or include relative to the benchmark index holdings. By comparison, a passive ETF attempts to replicate the index portfolio by holding the same or similar securities, or a representative sample, at the same proportions as the index.

Active ETFs generally seek to outperform their benchmark index rather than simply matching the return of that index. Wherever there are inefficiencies in the markets, such as in emerging markets or mid- and small-cap sectors, there are opportunities for active management to generate higher returns. Investors interested in these market sectors may want to consider active strategies.

One challenge of investing in products indexed to small- and mid-cap benchmarks is that an index investor will seek to replicate the benchmark portfolio through owning the same securities or a representative sample. However, a significant number of companies within these indices have no earnings. Even the S&P indices, which have a profitability screen for inclusion, carry a meaningful exposure to non-earners. (See “Benchmarks have exposure to non-earners”)

This dynamic has long been an important part of the case for active investing in the small- and mid-cap space. Strong active managers will generally focus on higher‑quality companies and will underweight non-earners in their portfolios. Even when active managers do choose to own non-earners, they are vetted, and the manager will typically have a view on their path to profitability. The value in avoiding, or at a minimum being underweight in, non-earners is clear. Profitable companies in the Russell 2000 Index have outperformed non-earners by 1,151% since December 31, 1999.³

As information has become more readily available to all investors, markets have generally become more efficient. Yet the small- and mid-cap equity markets remain relatively inefficient compared with large-cap markets. These asset classes tend to be less followed by sell-side analysts than large-cap equities, which gives investors with access to dedicated analysts the potential to derive an information advantage that can lead to increased alpha potential. (See “Average number of sell-side estimates per S&P index.”)

A dedicated investment team to support portfolio manager decision-making is as important as ever. Small- and mid-cap equities remain a fertile hunting ground for investment managers with the right resources to uncover alpha potential.

As the cost of being a public company has risen and the number of companies staying private for longer continues to grow, we have seen a decrease in publicly traded companies in the U.S., from more than 7,000 in 1998 to fewer than 3,400 today.⁴ As a result, the quality of small-cap indices has deteriorated significantly. (See “Benchmarks have exposure to non-earners.”) More than 40% of the Russell 2000 Index, and therefore 40% of the assets in ETFs that track the index, have experienced losses. A study by Furey Research Partners shows that the median return on equity of the Russell 2000 has fallen from 12.6% to 5.5% over the same period.⁵

Investors define quality in many ways. To show a simple comparison, consider the Russell 2000 Defensive Index and the Russell 2000 Index. (See “Higher quality has outperformed over full market cycles.”) The Russell 2000 Defensive Index represents U.S. small-cap stocks that exhibit a combination of high return on assets, low debt to equity, low earnings variability, and low long- and short-term total return volatility. These factors are all associated with quality. At T. Rowe Price, our analysts and portfolio managers do not specifically screen for stocks with these characteristics, but our fundamental bottom-up stock selection process typically leads us to names with these and similar attributes. T. Rowe Price small-cap strategies tend to overweigh these characteristics relative to their respective benchmarks; the Russell 2000 Defensive Index is a suitable proxy for this analysis. T. Rowe Price’s active approach, with a focus on quality, has been successful over time.

The majority of small- and mid-cap assets are invested in mutual funds over ETFs. (See “Active ETFs are underserved in the small- and mid-cap space.”) An investor’s decision to invest in these vehicles has several considerations:

When Thomas Rowe Price, Jr., launched his first small‑cap fund in 1960, it was among the first small‑cap funds in the market.⁷ Small‑ and mid‑cap investing is core to the T. Rowe Price DNA, and our investment success has led the firm to become the largest active manager of U.S. small‑ and mid-cap equities. (See “Experience and strength in the small‑ and mid‑cap market.”) The strategies developed over the many decades spent actively managing mutual funds apply directly to actively managing ETFs. All of the firm’s experience, resources, analysis, and expertise can be leveraged in the ETF space.

TMSL favors stocks that appear inexpensively valued relative to their respective industries and equity universes, with substantial free cash flow and a high return on capital with attractive relative valuation, improving earnings and cash flow, high return on capital, attractive operating margins, and sound balance sheet and financial management. The portfolio typically invests in between 240 and 270 equities in which our managers have the highest level of confidence. These securities fall within the core-, growth-, and value‑oriented spaces. While the macro environment should present opportunities in 2025, process and philosophy is driven by fundamental stock selection. The portfolio employs a bottom-up approach, where the managers select stocks they feel have potential to offer the most compelling upside.

Investors who have already considered the benefits of active management in small- and mid-cap sectors and have already invested in active funds now have new opportunities to consider in actively managed ETFs. Active ETFs, as with all actively managed funds, provide investors with the opportunity to benefit from professionals with the expertise and resources to make the best decisions based on the information on hand in these sectors.

Call 1-800-225-5132 to request a prospectus or summary prospectus; each includes investment objectives, risks, fees, expenses, and other information you should read and consider carefully before investing.