The second quarter opened with a rout after U.S. President Donald Trump announced his tariff plan on April 3, with tariffs to be raised several dozen percentage points. The S&P 500 erased $2.4 trillion in value in a single day, the steepest one-day loss since the pandemic. Small-cap stocks were hit harder by the selloff. Between April 2 and April 8, the small- and mid-cap Russell 2000 plunged 14%, versus a 12% decline in the large-cap S&P 500.

Freedom Finance Global analysts have outlined which sectors saw hedge fund outflows in the second quarter and which saw inflows, and highlighted the most actively traded small-cap names in the Russell 2000.

How hedge funds invested in 2Q

The most notable trend of the second quarter was a reduction in hedge fund exposure to the healthcare sector: its weight in portfolios declined 1.7 percentage points to 21%. Analysts at Freedom Finance Global said the move was expected, as healthcare stocks suffered a sharp drawdown during the period, with the iShares Biotechnology ETF down as much as 15% at one point.

Even so, health care remains the largest hedge fund position, with its weight 5 percentage points above that in the Russell 2000 index. “This may be due to the traditionally strong interest of funds in biotechnology companies, where many are making long-term bets,” Freedom Finance Global noted.

At the same time, hedge funds increased allocations to cyclical industries. The share of industrials rose by 1.4 percentage points to 18.0%, while information technology climbed 1.2 percentage points to 12.9%. These two sectors staged “a phenomenally fast recovery after the April selloff and by the end of the quarter had returned to record highs,” Freedom Finance Global said. Still, analysts pointed out that despite strong demand, IT’s share in hedge fund portfolios remains 1.3 percentage points below its weight in the index, suggesting some managers view multiple tech valuations as stretched.

Financials were little changed at 15.7% of hedge fund portfolios, versus 19.0% in the Russell 2000. According to Freedom Finance Global, managers remain cautious on the sector amid concerns that potential rate cuts could pressure small banks’ margins.

Overall, Freedom Finance Global noted that hedge fund positioning across sectors has become more balanced. The four largest sectors are now broadly comparable in size, reflecting lower concentration and a more even distribution of capital across the key small-cap sectors.

Hedge funds' top 10 small-cap holdings

  • Chart Industries, a developer and manufacturer of liquefied natural gas supply systems with a market capitalization of $8.9 billion, appears in the portfolios of 537 funds. Since the start of the year, its shares have fallen 4.2%. According to MarketWatch, most Wall Street analysts have a neutral view on the stock: 14 rate the stock a "hold," while two advise a "buy." The average target price is $203.30 per share, implying 2.2% upside from current quotes.

  • Lumen Technologies ($4.8 billion market capitalization, in 532 funds) builds fiber-optic networks for AI applications. Its stock is down nearly 11% year to date. Seven analysts recommend a "hold," four a "buy," and two a "sell," Marketscreener data shows. The average target price is $5 per share, for upside of 6.4%.

  • Stride ($6.97 billion market cap, 521 funds), an online learning platform for entrepreneurs, has gained 53.6% this year. Analysts see further upside of 7%, with an average target price of $171.20 per share. Five analysts recommend a "buy," while two rate it a "hold."

  • Badger Meter ($5.3 billion market cap, 519 funds), a supplier of flow and water-quality measurement solutions, has dropped 14.3% since January. Still, Wall Street sees more than 30% upside, with a consensus target price of $238.70 per share. Analyst ratings are split: six recommend a "hold" and five a "buy."

  • Sterling Infrastructure ($8.3 billion market cap, 502 funds) has surged 62.5% year to date. All four analysts covering the stock recommend a "buy," with an average target price of $355 per share, nearly 30% above current levels.

  • InterDigital ($7.3 billion market cap, 497 funds), a research and development company specializing in wireless and video technologies, as well as AI, is up 47% year to date. Analysts are divided: four rate it a "buy," two a "hold," and one a "sell." The average target price is $266.50 per share, about 6% below the current market price.

  • Brinker International ($7.0 billion market cap, 489 funds) has gained 20.2% since January. Most analysts remain cautious: 15 of 19 recommend a "hold," while four advise a "buy." The average target price of $180.27 per share suggests 13.3% upside.

  • Hims & Hers Health ($10.0 billion market cap, 487 funds), which operates a telehealth platform, has risen almost 84% this year, though with high volatility. Nine analysts rate the stock a "hold," five a "buy," and two a "sell." The average target price is $50.66 per share, indicating nearly 14% upside.

  • Kratos Defense & Security Solutions ($10.9 billion market cap, 484 funds), a defense tech and software provider, has soared more than 144.5% year to date on enthusiasm for "loyal wingman" drones that fly with manned aircraft. Kratos could evolve from a niche player into a sector leader, though long procurement cycles and competition from major contractors remain risks, analyst Aldiyar Anuarbekov wrote in a column for Oninvest recently. Fifteen of 17 analysts rate the stock a "buy," while the other two recommend a "hold." The average target price is $70.40 per share, about 9% above current levels. 

  • AeroVironment ($11.9 billion market cap, 482 funds), a defense-technology company, has jumped 54.8% this year. Analysts remain bullish: all 13 covering the stock recommend a "buy," with an average target price of $298.42 per share, implying another 25% upside.

The hedge-fund top 10 looked different than in the first quarter, with Sterling Infrastructure, Hims & Hers, Kratos, and AeroVironment entering the list, Freedom Finance Global said.

What Wall Street analysts expect

Over the past month, the Russell 2000 has gained 8.5%, outpacing the S&P 500’s 3.4% rise. Wall Street analysts see the outlook for small-cap stocks increasingly tied to Fed rate cuts. Fed Chair Powell signaled in his August 22 speech at Jackson Hole that the central bank is prepared to cut rates at its September meeting.

"I think it means we have a dovish Fed again. That’s kind of a green light for small caps," Tom Lee, head of research at Fundstrat, told CNBC.

Smaller companies are largely reliant on external borrowing to fund their operations, and lower borrowing costs increase their available capital. Lower rates could also enable smaller companies to refinance their existing debt more cheaply, enabling them to then direct a chunk of their earnings to fuel growth and expansion, Reuters noted.

"Small caps finally broke out after Jackson Hole,” Lori Calvasina, RBC Capital Markets’ head of U.S. equity strategy, wrote in a note quoted by Bloomberg.

Powell’s dovish remarks sparked a broad market rally. On August 22, the S&P 500 gained 1.5%, the Dow Jones Industrial Average rose 1.9%, and the tech-heavy Nasdaq Composite advanced by a similar margin.

But the Russell 2000 notched the biggest gain, adding almost 4%. Investors injected the most cash into the iShares Russell 2000 ETF since November, Bloomberg wrote. 

"In the absence of major tariff news or other macro surprises, we think the Russell 2000 likely leads large caps in the coming weeks," BofA equity strategist Jill Carey Hall wrote in a note quoted by Bloomberg.

Tom Lee of Fundstrat told CNBC that some sectors within small caps may also have tailwinds on the horizon. For one, he said financials should be helped by a decline in mortgage rates. 

The AI translation of this story was reviewed by a human editor.

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