Small- and SMID-cap equities offer the potential for superior long-term growth, as they often represent emerging companies with room to scale, innovate and disrupt. These stocks can offer diversification across sectors, business models and economic sensitivities. And, since they tend to move in long-term cycles rather than large caps, they can also experience extended periods of leadership.

This segment of the market is typically less efficient, with less analyst coverage, reduced liquidity and greater volatility. While this can create uncertainty, it also provides an opportunity for active managers to uncover mispriced companies with strong fundamentals and long-term potential.

Our small-cap equity team takes a bottom-up, research-driven approach to identifying these opportunities. We focus on companies we deem to have durable competitive advantages, strong management teams and attractive reward-to-risk profiles—placing particular emphasis on return on invested capital (ROIC).

ROIC measures how effectively a company generates profit from the capital it deploys. Companies that consistently earn ROIC above their cost of capital tend to create long-term value, often reflecting strong business models and disciplined capital allocation.

In small- and SMID-cap markets—where business quality and management execution can vary widely—this lens is especially powerful. High-ROIC companies are typically better positioned to generate free cash flow, reinvest at attractive rates and compound value over time.

Despite the potential for stocks of high-ROIC companies to outperform over the long term, there are periods when they’ll underperform. High ROIC is a quality factor and tends to be consistent with stocks that show lower beta and realized volatility. This contributes to the long-term outperformance of stocks of high-ROIC companies since — in what has been described as a candidate for “the greatest anomaly in finance” — low-volatility stocks have historically outperformed high-volatility stocks over the long run.¹

As Figure 1 shows, over trailing five‑ and 10‑year periods to year-end 2024, lower‑volatility deciles of the Russell 2500 Index (“Index”) generated annualized total returns that outperformed the Index by about 11–12%. In contrast, the highest‑volatility deciles produced negative annualized returns, with the first decile delivering approximately -11% over five years and -9% over 10 years.

Figure 1²

Across full cycles, high quality, lower-volatility businesses led the Russell 2500

Decile 1 = most volatile

Decile 10 = least volatile

There are, however, periods when economic and market dynamics favor high-volatility stocks. This was the case in 2025, when these stocks posted notable performance, particularly in the third quarter. 

As Figure 2 shows, the highest‑volatility deciles delivered remarkable short‑term gains. The top decile returned about 36% in Q3 2025, 5% in Q4 2025 and 54% for the full year, while the second decile followed closely.

Figure 2³

The most volatile names have driven returns

Decile 1 = most volatile

Decile 10 = least volatile

Higher-volatility stocks tend to represent lower-quality, more speculative companies, so this type of environment tends to cause high-ROIC stocks, representing higher-quality companies, to underperform — as has occurred. However, leadership by high-volatility stocks has proven unsustainable in the past and we expect it to revert to lower-volatility, high-ROIC stocks at some point, favoring our strategy.

The United States economy entered 2026 with substantial momentum, but its future trajectory will depend in part on how quickly the conflict in the Middle East is resolved and its tangential effects on the economy. The extent to which the conflict affects inflation and, therefore, interest rates will be key.

Despite elevated uncertainty, we remain optimistic about improvement in the macroeconomic and earnings environment in 2026. Our approach remains focused on identifying companies with high and improving ROIC, strong competitive positioning and disciplined capital allocation. We believe this focus on durable value creation positions the strategy to perform across market cycles.

The SMID Cap Strategy remains modestly overweight higher-ROIC companies, and over the past several quarters, we’ve increased the weight in improving-ROIC companies and those leveraged to an improving cyclical backdrop. We’ve also reduced the Strategy’s weighting in the software industry because the sector has underperformed and faces unknown and unquantifiable impacts from AI.