What is a Small Cap Growth Fund?

Introduction

In our experience, small cap growth (SCG) funds are often treated as an afterthought rather than an essential component of an investor’s equity allocation. We strongly believe this is a missed opportunity, as SCG has historically been one of the highest returning sectors in the publicly traded markets. We created this guide to help investors familiarize themselves with the asset class and more effectively navigate the small cap growth market.

Perhaps the easiest way to conceptualize a small cap growth fund is to look at an equity style box, shown below. The x-axis spans the continuum from value to growth, while the y-axis shows size. In theory, the style box is a straightforward way to categorize the vast universe of publicly traded equities, but in practice the boundaries are blurry. In this primer, we attempt to provide the most common small cap growth definitions while also sharing our own perspective on the subtleties of the asset class.

What is a Small Cap Fund?

A quick internet search reveals that most sites define small cap stocks as companies with market capitalizations between $300 million and $2 billion. However, the majority of both passive and active small cap funds hold companies well in excess of that threshold.

For example, there are two major small cap indices in the United States: the Russell 2000 and the S&P 600. As of November 30, 2024, the weighted average market cap of the Russell 2000 was $4.0 billion, and the largest company was $17.3 billion. Likewise, the weighted average of the S&P 600 was $3.8 billion and the largest company was $9.7 billion. Most actively managed small cap funds invest in the constituents of the small cap indices, so they also regularly own companies larger than $2 billion.

Given that the $2 billion threshold is largely theoretical, we recommend looking at a fund’s benchmark and its holdings, rather than its average market, cap to determine if it is investing in small caps. Whether it is active or passive, as long as it is tracking a reputable small cap index, it should be providing access to the small cap portion of the market.

What is a Growth Fund?

A growth fund is made up primarily of growth stocks, which are shares of companies that are expected to grow faster than the market. However, there is no standard, quantifiable definition of “growth” because there are so many different metrics one can use to evaluate a company’s potential. As a result, each index, as well as each fund manager, uses their own methodology.

The Russell 2000 Growth Index, which is the growth subset of the Russell 2000, uses a fairly complex methodology, focusing on stocks with “relatively higher price-to-book ratios” and “higher sales per share historical growth (5 years)” as well as companies with “higher” two-year growth forecasts in the Institutional Brokers' Estimate System. Meanwhile, the S&P 600 Growth Index considers just three factors: “sales growth, the ratio of earnings change to price, and momentum.”

The two indexes clearly define growth differently, so it is not surprising that managers do, too. In our case, we tend to focus on top-line revenue growth — generally we look for companies that have grown at least 20% over the past few quarters. We also look at a variety of other metrics, including margin growth rates and valuation ratios.

Managers also have different views about profitability. Some are willing to buy fast-growing companies that are losing money, as long as the top line growth is robust and consistent. Others require at least some profitability before they will invest. In our fund, we strongly prefer profitable companies but will occasionally deviate when we feel the fundamentals make sense.

Are There Different Types of Growth?

Generally speaking, investors divide “growth” into two categories: cyclical vs. secular. Cyclical growth tends to be highly correlated with the health of the macro economy — an obvious example is the travel industry. When people are employed and have disposable income, they tend to spend more on vacation and vice-versa. Secular growth, on the other hand, is driven by structural changes in demand. eCommerce is a good example — once consumers began to adjust to the idea of shopping online, its popularity grew steadily regardless of the macro conditions.

In our view, companies that are driven by secular growth are generally much better investments than cyclical growers. We will occasionally take positions in cyclical companies, but our basic view is that companies benefitting from secular tailwinds tend to be innovators that are proactively creating expanding markets for themselves.

Returning to the eCommerce example, think of all the ways Amazon.com has evolved over the years to make online shopping easier and thus more ubiquitous. It has not passively benefitted from changes in customer preferences. Rather, it has continually expanded its services to meet the needs of its users, which has significantly increased the number of people who shop online.

When evaluating small cap growth funds, we recommend focusing on managers who prioritize secular growth. Cyclical growth can be a nice supplement to a portfolio, particularly when the economy is doing well, but generally the best performing companies are those that tap into durable secular trends. Click here to learn more about why we believe secular growth is so important to an investment portfolio.

What is the Composition of the SCG Universe?

The small cap growth universe is concentrated in the following sectors: Health Care, Industrials, Information Technology, Consumer Discretionary, and Financials. As of December 31, 2024, the first three sectors in this list made up over two-thirds of the Russell 2000 Growth Index, and collectively, those five sectors accounted for 85% of the index.

The sector weightings of the index tend to be fairly stable, and not surprisingly, each of the top three are areas of the economy where innovation (i.e., secular growth) is the norm. Health care, for example, is constantly improving itself. When a new medicine or technological approach breaks through, adoption can be quite rapid, resulting in strong, sustained revenue growth. Likewise, disruptive industrial and information technology businesses often experience strong secular growth once their products begin to take market share from incumbents.

Small cap growth companies also tend to be younger businesses, although there are exceptions. Many have entered the market through an initial public offering (IPO) within the past few years, but, as we have previously written, we think it makes sense to wait several months after an IPO before investing in a new public company. The IPO pipeline is very important to the small cap universe because the best-performing small stocks inevitably graduate to a larger index, so it is essential that new, promising companies continue to emerge.

What Are the Risks of Small Cap Growth Funds?

In finance, as in life, there are no free lunches, and in exchange for the opportunity to achieve higher returns, small cap growth stocks have historically been more volatile than large caps. (This makes sense, as investors typically demand more return for riskier assets.)

As you can see from the chart below, after losing more than the S&P 500 in the 2002, 2008, and 2018 selloffs, the Russell 2000 Growth Index cumulatively outperformed in the subsequent two-year periods. This is what we would expect from small cap growth stocks — more downside in bear markets with the potential for faster growth during the recovery periods. Note that this pattern did not recur following the 2022 selloff, as the extended AI rally disproportionately benefitted the megacap technology companies in the S&P 500.

Taking a more quantitative view, the table below contains the historical risk/return characteristics of the Russell 2000 Growth Index vs. the other small cap indexes and the S&P 500. As expected, for the past 20 years, the returns of the small cap growth index have exceeded that of both the overall small cap index and the small cap value index, though they have slightly lagged the S&P 500’s return. Also as expected, the small cap growth volatility, as measured by standard deviation, has been slightly higher than both the other small cap indexes and the S&P 500.

Interestingly, if we exclude the post-pandemic years, which featured a rare combination of surging inflation and higher rates, both of which are particularly bad for smaller companies, the small cap growth index outperformed the other small cap indexes and the S&P 500.

Does Active Management Work Better for Small Caps?

Although passive investing has become a progressively larger share of the mutual fund/ETF landscape over the past few decades, a recent study by Morgan Stanley suggests that may be the wrong approach for small cap investors.

As the chart below shows, over the last 30 years, the cumulative median alpha generated by an active manager in U.S. small caps has been almost 60%. On the other hand, the cumulative median alpha has been negative for U.S. mid (-14%) and large cap (-17%) active managers.

As we have previously written, we believe that there are several reasons small cap managers continue to add more alpha than other active managers do. Most importantly, the small cap universe contains the highest concentration of mispriced companies in the public markets, as it has comparatively less analyst coverage and more companies with shorter track records. Thus, managers with strong due diligence practices and a disciplined buy/sell approach can find promising companies before they become widely known and exit when valuations are no longer attractive. This has been consistent with our own experience, as we have been able to outperform the Russell 2000 Growth Index since our inception.

What is the Role of Small Cap Growth in a Portfolio?

In our view, small cap growth is a strategically important asset class that belongs in most equity portfolios. The diversification benefits of holding small cap stocks alongside large and mid cap stocks are well established. Combining securities that are not perfectly correlated generally reduces portfolio volatility, as price movements tend to offset one another, particularly over the long term.

While investors must determine their specific allocations based on risk tolerance and investment objectives, we believe a market-weighted portfolio is a sensible starting point. In other words, investors should consider holding each asset class roughly in proportion to its representation in the broader market.

Still, this leaves the question of investing in small caps generally versus small cap growth or small cap value. We strongly believe that small cap growth is the most appropriate choice for investors seeking small cap exposure.

For us, the logic is straightforward. Most investors rely on their equity portfolios to generate the bulk of their long-term returns. Therefore, investing a small portion of your portfolio in young, innovative companies with the potential to outperform the market seems like a natural approach, particularly for individuals with multi-year investment horizons. In our view, excluding small cap growth from an equity allocation is a little like voluntarily driving below the speed limit.

As we mentioned earlier, small cap growth does not always outperform large cap stocks, but there have been extended periods where it has. The chart below shows that the Russell 2000 Growth outperformed the S&P 500 from 2003 to 2021.

Final Thoughts

Although small cap growth may not be a focus for investors, we believe it is an important asset class for equity allocations. Beyond the academic arguments about diversification, the small cap growth universe contains a disproportionately high concentration of the fastest growing companies in the public markets, which should increase the odds of generating above-market returns.

Moreover, savvy portfolio managers can select high-quality companies within that fast-growing ecosystem, which allows them to generate even stronger returns. Some of the biggest companies in the world began as small caps, and owning just a few of those kinds of stocks can materially boost returns over a long time horizon.

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