This small-cap fund is outperforming the Russell 2000. Here's how it works

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The Russell 2000 may have a profitability problem.

Though the small-cap index gained 10.1% in July, it's dropped roughly 4% so far in August, as of Thursday morning.

ALPS' Paul Baiocchi chalks up the volatile moves to the index's overall composition, with an estimate from Apollo Global showing 40% of those companies have negative earnings.

"[Investors] have basically resigned themselves to the fact that by being in the Russell 2000, I'm just going to have to take the good with the bad," the firm's chief ETF strategist told CNBC's "ETF Edge" this week.

To avoid the profitability drag, Baiocchi suggests investors prioritize quality companies, looking at more selective exchange-traded funds such as his firm's ALPS O'Shares U.S. Small-Cap Quality Dividend ETF Shares (OUSM).

«The idea is quality companies that pay and grow their dividends, and importantly, have less volatility than their peers,» he said. «It allows advisors and investors who have seen small caps go sideways for five years to be allocated to a category that's lagged.»

In addition to its profitability screen, the fund contains just 107 stocks — a fraction of what's inside the Russell 2000. Its top three holdings are Tradeweb Markets, Juniper Networks and Old Republic International, each sitting at a roughly 2% weighting in the fund, per FactSet.

Shares of the small-cap fund are down 1.5% month to date — outperforming the Russell by more than 2 percentage points in that time.

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