Generally, passive investing has transformed the way investors access markets. In many asset classes, it’s difficult to argue against the combination of low costs, broad diversification (when desired), and benchmark-like returns.
Small-cap stocks, however, tend to present a more nuanced case.
Compared with larger companies, smaller businesses typically receive less analyst coverage, exhibit a wider range of trading liquidity, and vary more in financial quality. Those characteristics don’t guarantee that active managers will outperform. They do, however, create a market where fundamental research, disciplined security selection, and dynamic portfolio construction may have greater potential to add value than they do in more efficient parts of the market.
In short, the active-versus-passive debate may deserve a different conversation when it comes to small-cap stocks.
Active and passive strategies are often designed to achieve different investment objectives.
Passive investing is designed to deliver exposure by tracking an index, commonly used to represent a market or market segment, as efficiently and inexpensively as possible. Index construction follows a predefined, rules-based methodology that determines which securities are included and how they are weighted.
Active management often一but not always一seeks an objective beyond exposure itself. That may mean outperforming a benchmark, managing risk, generating income, or building a portfolio with distinct characteristics. Portfolio managers pursue those objectives through discretionary security selection, portfolio construction, and capital allocation.
Neither approach is inherently better. The more useful question is whether a rules-based approach or active investment judgment better aligns with an investor’s objectives.
Not all markets present the same opportunity for active management. Large-cap developed equities are generally considered among the most efficient, where extensive research coverage and rapid information flow leave relatively little room for sustained informational advantages.
Small-cap stocks, by contrast, can exhibit greater differences among companies and a wider range of investment outcomes, potentially creating more opportunities for fundamental research and security selection to influence results.
According to Russell Investments, large-cap companies are followed by an average of 16.4 analysts, compared with roughly 5.7 analysts for small-cap companies. Of course, less coverage doesn’t automatically create mispriced stocks. Markets are remarkably efficient much of the time. But fewer analysts, fewer institutional investors, and fewer published opinions can create a larger information gap—one that fundamental research may help exploit.
Just as important, small-cap companies as an opportunity set generally exhibit greater variation in business quality, financial strength, and growth prospects than larger companies.
Even two companies with similar market capitalizations can have dramatically different financial profiles. One may be consistently profitable with a strong balance sheet and durable competitive advantages. Another may still be dependent on external financing, concentrated in a handful of customers, or operating in an industry facing structural challenges.
Those differences often don’t become clear from a quick screen of valuation ratios.
They require a deeper assessment of factors such as:
We believe that the last point is particularly important.
Many successful investments are driven not simply by buying a good company, but by identifying what could improve its prospects before the broader market fully recognizes it. A new management team, margin improvement, debt reduction, expansion into new end markets, or an industry recovery can all serve as catalysts that change how investors value a business.
A passive strategy owns companies because they satisfy the rules of an index. An active manager has the opportunity to ask different questions: Is the balance sheet improving? Does management have a credible capital allocation strategy? Is earnings growth sustainable? Has the market fully recognized the potential catalyst—or is there still an opportunity?
Sometimes, avoiding weaker businesses can contribute just as much to long-term results as identifying future winners.
Liquidity varies considerably across the small-cap universe. In its 2022 review of the Tick Size Pilot, the SEC found that small-cap stocks exhibit markedly different trading characteristics, with the least liquid companies responding very differently to changes in market structure than their more actively traded peers. This highlights that liquidity can be far from uniform within the asset class.
Additionally, small-cap stocks often trade less frequently than their larger counterparts. Recent NYSE market-quality data show that less liquid stocks tend to exhibit wider bid-ask spreads, lower trading activity, and thinner displayed market depth than more actively traded securities. Together, these characteristics can increase transaction costs and amplify the price impact of larger trades.
These findings are consistent with the SEC’s earlier, broader analysis of U.S. equity market quality, which documented a clear relationship between company size and liquidity, with smaller companies generally exhibiting wider spreads, lower trading volume, and shallower markets. Although that study analyzed 2013 market data, it remains one of the SEC’s principal references on the structural relationship between market capitalization and liquidity.
This affects both active and passive investors.
Passive funds may need to buy or sell securities as money flows into or out of the fund, or when benchmark changes occur, regardless of whether trading conditions are favorable. Active managers, meanwhile, typically have greater flexibility in how they build or exit positions. They may spread trades over time, limit position sizes, or avoid companies whose shares cannot be traded efficiently.
Today’s investment landscape provides a useful example of how active managers often think about opportunity.
Much of the market’s recent attention has centered on the largest technology companies investing billions of dollars in artificial intelligence (AI). As the primary builders and providers of AI hardware, software and cloud infrastructure, these companies have been among the most visible beneficiaries of the AI investment cycle so far.
The less visible question is what it actually takes to build out that vision.
Hilton’s Small & Midcap Opportunities portfolio manager Tom Maher recently suggested that the companies constructing data centers, expanding power infrastructure, providing engineering services, or supplying specialized technology may become important second- and third-order beneficiaries as AI investment broadens. Many of these businesses sit in the small- and mid-cap universe.
This illustrates the type of research active managers perform every day: looking beyond the companies already dominating headlines to identify businesses whose earnings, competitive position, or long-term outlook may improve as broader industry trends evolve.
Historical performance comparisons often conclude that passive investing outperforms active management. While those studies provide valuable perspective, they don’t always capture the full context of the active-versus-passive comparison.
As discussed earlier, active and passive strategies are often designed to achieve different objectives. Passive investing seeks to deliver market or market segment exposure at a low cost, while active managers may pursue a range of goals market exposure alone may not be able to deliver.
Accordingly, different approaches help explain fee disparities. Passive funds replicate an index through a rules-based process. Active managers run research teams, conduct fundamental analysis, and build portfolios security by security in pursuit of their stated objectives. That work carries a cost, which raises the bar on performance.
In effect, every dollar paid in fees is a dollar that cannot compound, so active managers must clear their expenses before they can deliver better net results than a lower-cost passive alternative. Morningstar notes that even small fee differences can meaningfully affect long-term outcomes. And finding managers who can consistently clear that bar after fees can be notoriously challenging, making manager selection central to the performance equation.
For investors who conclude that active management in small cap aligns with their objectives, the next decision becomes how to access it.
For many, an active small cap ETF may offer an attractive alternative to a traditional actively managed mutual fund. Like passive ETFs, active ETFs trade throughout the day on an exchange, offer daily transparency, and may benefit from the tax efficiency associated with the ETF creation and redemption process.
They have also become increasingly cost-competitive. Morningstar’s category data as of September 2025 show that small‑blend, small‑growth, and small‑value ETFs all carry lower average expense ratios than comparable open‑end mutual funds, with investors saving roughly 0.30% to 0.50% in annual fees by using the ETF structure.
An active small- or small- and mid-cap (SMID) ETF can serve as a portfolio’s primary vehicle for equity exposure beyond large-cap equities. Combining small- and mid-cap companies may provide a lower-risk profile than a dedicated small-cap allocation while still expanding exposure beyond the large-cap universe.
For portfolios weighted toward large-cap holdings, an active small-cap ETF can help extend exposure across the market-capitalization spectrum. Expanding into this segment may support a more balanced equity allocation, one that isn’t dependent on the fortunes of the largest companies alone.
Market leadership often rotates—between market-cap segments, styles, sectors, and industries. An active approach can adjust across those dimensions in pursuit of stronger returns, rather than holding a fixed allocation regardless of where opportunity is emerging. That flexibility is precisely what a rules-based index cannot offer.
The active-versus-passive debate is often framed as a contest of averages: does active management, on the whole, beat its benchmark after fees? That framing has some pull for large-cap equities, where more efficient pricing and wider coverage leave less room for security selection to make a meaningful impact.
Small caps can complicate that framing. Wider dispersion in analyst coverage, financial quality, and liquidity means the distance between the best and worst outcomes is more pronounced—not proof that active managers will outperform, but evidence that skill has more room to matter here than in more efficient markets.
Choosing an active small-cap ETF isn’t a bet that active beats passive in the abstract. It’s a bet that a disciplined process, applied where the opportunity set can be more robust, can identify what a rules-based methodology isn’t built to see.
To learn more about how an active small-cap ETF strategy may fit your investment objectives, contact our team today.
Important Disclosures:
Hilton Capital Management, LLC (“HCM”) is a Registered Investment Advisor with the US Securities Exchange Commission. The firm only transacts business in states where it is properly notice-filed or is excluded or exempted from registration requirements. Registration as an investment advisor does not constitute an endorsement of the firm by securities regulators nor does it indicate that the advisor has attained a particular level of skill or ability.
The Hilton Small-MidCap Opportunity ETF (SMCO) is one example of an actively managed ETF in the small- and mid-cap equity space. This material is provided for educational and informational purposes only and should not be construed as investment advice, a recommendation, or an offer to buy or sell any security or investment product. The information presented is general in nature and does not take into account any investor’s individual investment objectives, financial situation, risk tolerance, or needs.
Investing involves risk, including the possible loss of principal. Active ETFs are subject to management risk, market risk, trading risk, liquidity risk, and the risk that the fund’s investment strategy will not achieve its objective. ETF shares may trade at a premium or discount to NAV, and brokerage commissions or other transaction costs may apply. Past performance does not guarantee future results.
Before investing in any ETF, investors should carefully consider the fund’s investment objective, risks, charges, and expenses. This and other information is available in the fund’s prospectus and summary prospectus, which should be read carefully before investing.
All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Sources include: Russell Investments, U.S. Securities and Exchange Commission, New York Stock Exchange, and Morningstar, Inc. There is no representation or warranty as to the current accuracy, reliability or completeness of, nor liability for, decisions based on such information and it should not be relied on as such.
Additional Important Disclosures may be found in the HCM Form ADV Part 2A, which can be found at https://adviserinfo.sec.gov/firm/summary/116357.