3 Small-Cap Funds Set for a Rebound

Many small-cap funds lagged their benchmarks by wide margins in 2025 while putting up respectable absolute returns. Strategies that eschew speculative small caps and focus on higher-quality companies, however, fell 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. At the end of 2025, the Russell 2000 Index had about 8% in businesses that have never been profitable, mostly biotech stocks. In 2025, such stocks gained about 42%, nearly 3 times that of the overall index. Swelling stock valuations, rather than underlying business improvements, drove the gains as the price/sales ratio of the average profitless stock jumped from the midsingle digits at the year’s start to almost 20 by year-end. In other words, market participants were willing to pay higher prices for the promise of future earnings rather than actual current profits.

Some 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, and the S&P SmallCap 600 Index, which requires constituents to be profitable for at least four quarters before joining the benchmark, shows the difference that profitability makes. From the S&P SmallCap 600’s late-1994 inception through 2025, its 10.6% annualized gain beat the Russell 2000’s by 1.4 percentage points. The outperformance was consistent, too. The S&P SmallCap 600 beat the Russell 2000 in 94% of rolling five-year periods.

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 outpaced the S&P SmallCap 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.

Here are three highly rated funds to consider. They remain sound despite stiff headwinds and recent underperformance.

Champlain Small Company CIPSX, which has a Morningstar Medalist Rating of Gold, starts with the S&P SmallCap 600 and sticks to the industrials, consumer staples, healthcare, technology, and financials sectors—areas where its managers can add value. The managers look for superior relative growth and 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 18.5 percentage points and landed in the small growth Morningstar Category’s bottom decile.

Baron Small Cap 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 companies are rarely bargains, manager Cliff Greenberg buys when they are attractively priced relative to their long-term earnings prospects. The Silver-rated fund trailed the Russell 2000 Growth Index by 14.0 percentage points and landed in the small-growth category’s bottom quintile for 2025.

Gold-rated Boston Trust Walden Small Cap BOSOX 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 the most resilient in down markets. Conversely, the strategy tends to lag in rallies, particularly those led by the lower-quality businesses it typically avoids. Thus, results in 2025 trailed the Russell 2000 Index by 16.8 percentage points and landed in the category’s bottom decile.

This article first appeared in the January 2026 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor by visiting this website.