By James MacGregor, Bruce Aronow, Samantha S. Lau, Shri Singhvi The pullback in smaller US stocks over the past year offers a compelling opportunity for investors who want to restore their exposure to the asset class. But how they go about it matters. Even with a modest recovery this spring, absolute valuations for small-caps remain below their historical average. And after two years of underperforming large-caps, small-caps also look cheap relative to their larger peers. As we detailed in a previous blog post , we think the punishment that small- and mid-cap (SMID-cap) stocks endured during the recent downturn was unwarranted, and we expect a rebound as risk appetite returns. That’s why today’s valuations in much of the small-cap universe look so attractive. For investors who may have lightened up on their holdings, now looks like a good time to reload. Choosing the Right Investment Strategy Still, the strategy investors choose can make all the difference. Investors have lately been putting more money in exchange-traded funds and passive mutual funds that track small-cap indices, such as the Russell 2000 Index. This mirrors the popularity of passive strategies in other asset classes. Here’s the problem: the small-cap market isn’t as efficient as the one for large-caps, and shares are often misunderstood – and mispriced. Over time, a hands-on, active approach has produced better results (Display) . We don’t see that changing, and we suspect passive strategies will benefit less from a small-cap recovery. Click to enlarge Digging Deep and Adding Value Why do active managers have an advantage? To start with, smaller companies get less research coverage than larger ones, so their business models and prospects are not always well understood. Active managers can add value by digging into fundamentals and identifying fast-growing companies that the rest of the market has underestimated or overlooked. Think of it as finding a Netflix (NASDAQ: NFLX ) before video streaming takes off. An active approach works better for value-minded investors, too. Because smaller companies get less attention from analysts, their shares tend to get hit harder than large-cap stocks when markets get volatile. But a bigger price decline means more opportunity for managers to add value. For instance, managers who can distinguish between companies most likely to recover quickly, and those that face steeper challenges stand a good chance of boosting returns and creating value for investors. The Drawbacks of Indexing Of course, not every small-cap stock or sector is cheap today. Investors abandoned most small-cap sectors during the sell-off, but not all. A clutch of “safer” sectors that tend to deliver more stable earnings bucked the trend. These included value-oriented sectors such as utilities and real estate investment trusts (REITs), the so-called “bond proxies.” In the growth space, biotechnology- and Internet-related names also attracted sizable inflows during the multi-year run-up that peaked last summer. These sectors have done very well over the past few years – so well, in fact, that they now look overpriced relative to the rest of the market. But if you’re using a passive, index-tracking strategy to gain access to the market, you’re pouring a lot of money into these sectors, which account for a large share of the broader market. Utilities and REITs, for instance, comprise almost one-quarter of the Russell 2000 Value Index (Display) . Click to enlarge While these sectors have done well during the small-cap pullback, we think they have much less room to rise in the future. The rest of the smaller-cap market, on the other hand, looks attractive, and we think it will outperform in an equity market recovery. A skilled active manager can be choosy and zero in on high-quality, inexpensive stocks that have the most potential to deliver strong returns, while avoiding the pricey ones. Investors who rely on passive vehicles, on the other hand, may miss a good share of any small-cap rebound, because these vehicles, by design, will have large positions in the most overvalued sectors. We think reallocating to a small- or SMID-cap portfolio can boost investors’ return potential. But the key to success, in our view, comes down to strategy. Active managers can structure their portfolios so they benefit only from the risks that are being mispriced. A passive approach can’t match that. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. James MacGregor, CFA, is Chief Investment Officer – Small and Mid-Cap Value Equities Bruce K. Aronow, CFA, is Chief Investment Officer – US Small/SMID-Cap Growth