The debate between active and passive investing is especially pronounced in the U.S. small-cap equity market. Advocates of active management argue that small caps represent a less efficient segment of the market, offering opportunities for skilled managers to generate alpha (returns above benchmark). On the other hand, proponents of passive investing point to consistent long-term data showing that most active small-cap managers underperform benchmarks over extended periods.

Putnam Investments argues that the small-cap segment is relatively inefficient due to limited analyst coverage, lower liquidity, and thinner trading volumes. This inefficiency creates more opportunities for skilled managers to identify mispriced securities and generate alpha. Through an active approach, investors can achieve a selective exposure to higher quality stocks and avoid unprofitable companies that typically plague small-cap indexes. 

Furthermore, structural changes in index composition have weakened overall quality. Over time, the types of companies that make up small cap indexes have shifted to include more financially risky or economically sensitive firms than in the past. Small-cap indexes, particularly the S&P 600, have become more cyclical and credit risk-laden, reducing their appeal for passive buy-and-hold investors. A study done by Natixis Investment Managers shows that the Altman Z-Score distribution, a formula used to estimate a company’s likelihood of bankruptcy, has weakened across the small-cap index, suggesting an increasing number of companies in distress. The study also shows that over 20% of companies in the S&P 600 had negative earnings in 2024, compared to around 13% a decade prior.

However, long-term data overwhelmingly favors passive strategies.

First, there is overwhelming evidence of active management long-term underperformance for small caps. For example, S&P Global’s SPIVA report shows that about 80% of U.S. equity funds underperform their benchmarks over 10 years, based on risk-adjusted return. Even though some critique index composition, passive funds tracking benchmarks like the Russell 2000 or S&P 600 still provide broad exposure to the market. Despite periods of market stress, such as in 2001, 2008, or 2020, passive investors still came out ahead, says the SPIVA report. 

Second, active management outperformance is rarely persistent: SPIVA’s persistence scorecards show that top-performing funds in one period seldom repeat their success.

Survivorship bias further weakens the case for active investing, as unsuccessful actively managed funds tend to be merged or liquidated, artificially boosting statistical success rates. 

Third, for those opting to outsource their active management, high fees undermine returns. Overall, active funds, not just specifically restricted to small caps or even large caps, often charge fees between 1% and 3%, compared to around 0.1%-0.2% for passive alternatives, research from Wharton School finds. These fees compound over time and significantly erode returns. 

Active management can work, especially in short time frames, or when run by managers with disciplined risk controls and targeted strategies. In the small-cap space, these managers may navigate structural weaknesses in the indexes or apply thematic strategies. However, these cases tend to be the exception rather than the rule. For the vast majority of investors, passive investing offers greater consistency, lower costs, and better long-term odds.