Little-known China AI startup DeepSeek sent fear rippling throughout the markets this week by announcing major strides in its large language model technology at just a fraction of the cost of what many experts thought possible.
That sparked a mini-collapse among big-cap tech stocks like Microsoft, Google, and Nvidia, which tumbled 20% at its low. It also called into question whether AI projects could continue to develop and flourish with far less infrastructure spend. The news comes less than a week after Meta CEO Mark Zuckerberg announced plans to spend up to $65 billion on AI infrastructure projects this year.
Up until now, the dominant impact technology has had on the market’s gains reflects the significant rate at which tech profits have outpaced all other industries. But there’s no question that the risk/reward on the AI trade has worsened. Many Wall Street analysts expect the earnings growth gap between megacap tech drivers and the rest of the market to shrink this year.
All of this fuels investor appetite for diversification from large-cap concentration risks and more advisor interest in small- (typically with a market cap of $250 million to $2 billion) and midcap (often valued at $2 billion to $10 billion) companies. Lagging ripple effects from rate cuts and reshoring efforts under the new Trump administration may also serve to bolster the space.
The Active ETF Approach
Small-caps have underperformed broader equities for more than three years now, despite outshining the S&P 500 over the prior 30 years. Still, the smaller-cap pool remains broad, and plenty of lower-quality players are tainting the waters of this trade. Less analyst coverage can often result in mispricing or overlooked opportunities. That leaves the door wide open for active managers to seek out hidden gems. In many cases, investors must rely on stock selection expertise, or at least a systematic touch, to help them sift through the noise.
Right now, roughly $69 billion is parked in active small- to midcap ETFs. That’s only a tenth of the total passive small- to midcap ETF space. While active small-cap assets account for less than 10% of small-cap ETF AUM today. But they account for more than 75% of total small-cap mutual fund assets. It’s a similar story with the active midcap space.
Capital Group, one of the world’s largest active managers, just launched its very first U.S. Small and Mid-Cap ETF (CGMM) this month, fueled by what the company calls considerable pent-up advisor demand for active investing in the small- to midcap space. The fund applies deep fundamental research to identify what it calls potential “acorns to oaks” companies with up to $56 billion in market capitalization. CGMM charges an expense ratio of 0.51% and is relatively overweight financials, consumer discretionary, and consumer staples.
The largest existing small-cap ETF is the Avantis U.S. Small Cap Value ETF (AVUV ). It has accrued north of $16 billion in assets and has seen half a billion dollars in net inflows in just over one month. Primarily focused on companies trading at low valuations with high profitability ratios, the fund continues to be the star of the small-cap show. It’s pulled in roughly $5.5 billion in net inflows over the past year. American Century’s $1.5 billion Avantis U.S. Small Cap Equity ETF (AVSC ) has also done well.
Active powerhouse Dimensional has several systematic small-cap ETFs that have gathered sizable assets. These include the Dimensional U.S. Small Cap ETF (DFAS ), the Dimensional U.S. Small Cap Value ETF (DFSV ), the Dimensional International Small Cap ETF (DFIS ), and the Dimensional International Small Cap Value ETF (DISV ). All four funds have seen strong inflows in both the fourth quarter and over the past year.
Lately, active small-cap ETF launches have been trending up but at a slow and steady pace. Just 16 total new products came to market last year — still the most in any given year. Two such launches include the Neuberger Berman Small-Mid Cap ETF (NBSM ), which has 55 holdings that screen SMIDcap companies for quality, and the Rockefeller Small-Mid Cap ETF (RSMC), which uses a bottom-up, fundamental approach of roughly 35-45 U.S. companies. The latter has already gathered $800 million in assets. Two years ago, T. Rowe Price launched its own Small Cap ETF (TMSL ) that looks at a much broader universe of more than 260 stocks. The fund, which charges 0.55%, has risen 20% over the past year on a NAV basis.
Recent developments in the megacap tech sector underscore the increasing appeal of portfolio diversification. Actively managed ETFs provide investors the tools to navigate these less-followed and less-transparent markets more effectively. The recent uptick in new offerings is proof more investors and advisors are acknowledging the potential of smaller companies to generate more competitive returns and seize uncorrelated alpha.
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