The big rally in small caps has the Russell 2000 easily outpacing the S&P 500 this year. While large-cap tech titans dominate the headlines, small companies have been quietly making noise with investors who have already caught on to the trend. While some skeptics might view this as a fleeting, speculative trend, market fundamentals and broad participation suggest this rally has real legs. CNBC’s ETF Edge discussed this recently.

Key Takeaways:

• Today’s small-cap rally is supported by broad fundamental strength rather than short-term speculation, as evidenced by all 11 small-cap GICS sectors outperforming their large-cap counterparts.
• Actively managed ETFs from Avantis can systematically target higher-quality, profitable small companies while screening out distressed stocks.
• By focusing on real-time valuations and profitability, the Avantis U.S. Small Cap Equity ETF (AVSC) has managed to outpace the traditional Russell 2000 Index by more than four percentage points year-to-date.

See More: Navigating the Small-Cap ETF Disconnect

Rally Built on Depth and Breadth

Compared to previous rallies driven by short-term speculation, today’s small-cap outperformance is backed by broad economic strength. This comes despite typical headwinds that bog down small caps like high interest rates.

“You have all 11 small-cap GICS sectors outperforming their respective large cap GICS sectors,” said Matt Bartolini, Head of SPDR Americas Research at State Street, on ETF Edge. “That hasn’t happened in over 30 years, based on index data that goes back that far.”

Further data debunks the notion that the rally is a speculative trend. As Bartolini noted, small-cap companies with low short interest are outperforming those with high short interest. Bartolini explains that if this were a simple snapback junk rally or a short squeeze, the inverse would be occurring.

Furthermore, the structural health is bolstered by solid earnings momentum. Upgrades outnumber downgrades and third-quarter earnings per share (EPS) growth is projected to exceed 20%.

Active Execution: The Avantis Approach

Investors intrigued by the small cap rally can attain broad exposure via small-cap focused ETFs. Avantis has a dedicated suite of funds that is ideal for small cap exposure with factor and international tilts as well.

While funds that track an index like the aforementioned Russell 2000 can provide vanilla exposure, Avantis offers active, systematically managed ETFs like the Avantis U.S. Small Cap Equity ETF (AVSC) and the Avantis International Small Cap Equity ETF (AVDS). By using an active mandate, the funds’ portfolio managers can target higher-quality companies that a passive index may include when casting a wider net in the ocean of small caps.

Phil McGinnis, Chief Investment Strategist at Avantis Investors, noted that successful small-cap investing exists at the “intersection of that profitability, but price point.” Avantis ETFs still pursue the traditional benefits of indexing like high diversification, low turnover, and transparency. The active flexibility, however, allows funds like AVSC to target a diverse group of U.S. small-cap companies. They can adjust holdings based on real-time valuations, profitability metrics, and levels of investment.

When distressed stocks drop in price , they are automatically added to passive value indexes. Meanwhile, active managers can evaluate their momentum and balance sheet health before buying. McGinnis notes that this daily active oversight and an emphasis on valuations create a powerful combination that investors really appreciate. That said, AVSC is notably outperforming the Russell 2000 by over four percentage points year-to-date.

Meanwhile, AVDS expands this disciplined methodology globally. The fund invests in a broad set of non-U.S. small-cap companies. It weights securities based on the same critical factors as AVSC. Built to fit seamlessly into an investor’s global asset allocation, AVDS ensures that international exposure is managed with the same rigorous focus on fundamentals.

Given their active mandates, AVSC and AVDS both come with competitive expense ratios of 25 and 30 basis points, respectively. Both fall below their ETF Database and Factset Segment Averages.

Overcoming Large-Cap Bias

Many financial advisors and retail investors are still hesitant to reallocate from the safety of large caps. McGinnis suggests that investors should return to first principles and evaluate what “the market” actually means.

Relying solely on the S&P 500 misses entire segments of global growth. By utilizing low-cost, highly active funds like AVSC and AVDS, investors are able to construct more robust, diversified portfolios that can capitalize on the compounding growth of small caps over time.

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