4 Quality Small-Cap Funds for Long-Term Investors

Small-cap funds on average have lagged their benchmarks by wide margins this year while putting up respectable absolute returns. Strategies that avoid speculative small caps and focus on higher quality companies, however, have fallen even further behind in relative terms.

A big culprit was a rally in low-quality small-cap stocks. There are many ways to gauge quality, but one of the simplest and most revealing is profitability. The Russell 2000 Index currently has nearly 8% in businesses that have never been profitable, mostly biotech stocks. So far this year, such stocks have gained about 42%, nearly three times that of the overall index. Swelling stock valuations, rather than underlying business improvements, drove the gains; the price/sales ratio of the average profitless stock jumped from the midsingle digits at the beginning of the year to almost 20 recently. In other words, market participants were willing to pay higher prices for the promise of future earnings rather than actual current profits.

Many fund managers avoid these businesses for a good reason: They underperform over the long term. Comparing the long-term results of the Russell 2000 Index, which includes a lot of unprofitable businesses, with the S&P Small Cap 600 Index, which requires constituents to be profitable for at least four quarters prior to joining the benchmark, shows the difference that profitability makes.

From the S&P Small Cap 600’s late-1994 inception through Dec. 10, 2025, its 10.7% annualized gain beat the Russell 2000’s by 1.4 percentage points. The outperformance was consistent, too. The S&P Small Cap 600 beat the Russell 2000 in 94% of rolling five-year periods.

So, history suggests that investing in profitable businesses can be a reliable way to win and unprofitable stocks’ recent runup probably won’t last. Indeed, the Russell 2000 is on track to outpace the S&P 600 by a margin only seen during the dot-com bubble and 2020’s soaring market—two periods that subsequently saw violent reversals. Investors who wait for that reversal to happen often miss it. The time to start considering dollar-cost averaging into out-of-favor small-cap funds is now.

Good Funds Having a Terrible Year

Competitive small-cap managers catch the quality tailwind. Here are some funds with at least one High People or Process rating and disciplined, quality-oriented processes that remain sound despite stiff headwinds.

Champlain Small Company CIPSX, which earns High People and Process ratings, starts with the S&P Small Cap 600 Index and sticks to areas where its managers can add value, focusing mainly on industrial, consumer staple, healthcare, technology, and financial firms. They look for superior relative growth, capable management teams, as well as stable and predictable business models that aren’t too capital-intensive or reliant on external funding sources. Not owning biotech stocks hurt returns in 2025. The fund trailed the Russell 2000 Growth Index by 20 percentage points and landed in the small-growth category’s bottom decile.

Baron Small Cap Retail BSCFX focuses on businesses benefiting from long-term secular growth trends and competitive advantages that can steadily compound value over time. Established businesses with stable revenue and strong profitability metrics anchor the portfolio. While such firms are rarely bargains, manager Cliff Greenberg remains sensitive to valuation, buying when they are attractively priced relative to their long-term earnings’ prospects. So far this year, the strategy—which earns High Process and Above Average People ratings—trailed the Russell 2000 Growth Index by 17 percentage points and landed in the small-growth category’s bottom quintile.

Boston Trust Walden Small Cap BOSOX, which has High Process and Above Average People ratings, seeks businesses with durable and predictable earnings as well as reasonable valuations. That makes the strategy among the least volatile in the small-blend category and most resilient in down markets. Conversely, the strategy tends to lag in rallies, particularly those led by lower-quality businesses it typically avoids. Thus, results so far in 2025 trailed the Russell 2000 Index by 18 percentage points and landed in the category’s bottom decile.

Evaluating downside risk is also an integral part of Victory Sycamore Small Company Opportunity’s SSGSX approach. Lead manager Gary Miller thinks owning higher-quality businesses reduces downside risk so he invests in companies with superior profitability metrics. That approach drove long-term outperformance and reliable downside protection, but it tends to lag in sharp rallies—and 2025 was no exception. The strategy, which earns Above Average Process and High People ratings, landed in the small-value category’s bottom quintile and lagged the Russell 2000 Value Index by 12 percentage points.

Looking Forward

Low-quality rallies will come and go. Investors must pick strategies that can win over the long haul and be patient. Focusing on high-quality, profitable businesses is one way to do that. Aggregate profitability metrics like net margins, return on assets, and return on invested capital higher than those of the benchmark usually indicate a high-quality portfolio.

Using multiple benchmarks can also help. Businesses may choose to invest in future growth, which weighs on earnings. Skilled managers won’t overlook these opportunities, so the Russell 2000 Index (and its value and growth variants) can still be useful yardsticks—warts and all—as they reflect a broad small-cap universe. Investors who want to hold quality-oriented managers’ feet closer to the fire can use narrower quality-focused indexes, like the S&P Small Cap 600 or the Morningstar US Small Cap Quality Factor Index.