Confidence in small caps is currently riding high: the S&P/ASX Small Ordinaries Index has returned 21.5% so far this year (as of 13 November 2025) – roughly double the gain of the S&P/ASX 200 over the same period.

But picking small cap winners can be fraught with difficulty: small companies are sensitive to rising interest rates, inflation, vulnerable to earning shocks, and liquidity pressures when conditions tighten. Add to this the market inefficiencies that stem from limited analyst coverage of the sector, and small caps can trade at prices that diverge sharply from their underlying fundamentals.

These are precisely the reasons active investing in small caps makes sense over passive, index investing in small caps, according to Morningstar.

In its recent Active/Passive Barometer, it found active funds are most successful in Australian mid/small caps and global bonds while passive investing is more effective in large caps.

“Active managers maintain clear dominance within this category, supported by their ability to exploit pricing inefficiencies in relatively under researched segments of the market,” the report found.

Active managers in the Australian small and mid-cap sector outperformed passive managers over a three, five and ten year-basis in the period ending June 30, 2025, it added.

The median Australian small-cap active fund outperformed the S&P/ASX 200 Small Ords index by 1.8 percentage points (after fees) over three years, 2.2 percentage points over five years and 3.3 percentage points over 10 years.

In Australia, the case for active management in small caps is further magnified by the composition of the local small cap universe which is heavily weighted towards resource and mining companies. Morningstar data shows metals and mining stocks made up 16.9 per cent of the S&P/ASX Small Ordinaries Index (as of January 21, 2025) compared to 1.6 per cent in the US and 1.8 per cent in the UK.

In the report, Morningstar senior analyst Zunjar Sanzgiri notes that passive small-cap indices rely on narrow rules-based inclusions such as the S&P/ASX Small Ordinaries’ requirement to hold around 180 of the market’s smallest companies, including many low-quality mining and industrial names that active managers typically avoid.

By contrast, active small-cap managers can draw from a broader universe and build concentrated portfolios of between 30 and 40 higher-conviction stocks, giving them greater scope to generate excess returns.

Meanwhile, appetite for small cap investing is expected to continue:

More than 60% of advisers surveyed by Fidante recently said they are “bullish” or “very bullish” on Australian small caps. Around 44% of the 200 advisers surveyed as part of the annual Adviser Markets Survey said they plan to increase allocations to Australian and global small caps citing concerns about stretched valuations in large-caps and persistent market uncertainty.

Trading data from AUSIEX indicates strong adviser and retail activity in small-cap and emerging market ETF’s throughout 2025, reflecting renewed appetite for growth-oriented exposures. Total holdings value in small cap ETFs - such as Vanguard’s ASX:VSO and its international small companies index ETF ASX:VISM, Betashare’s Australian Small Companies Select ETF ASX:SMLL and VanEck’s ASX:MVS - by advised accounts have increased over 20% from April to the end of October, and three quarters of all trades are buys. The number of advised accounts holding small cap ETFs has increase 8.97% from January to end October and the net traded value (value of buy trades less sell trades) has been positive and increased strongly in September and October this year.

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