Small-Cap ETFs Set to Outperform After Fed Rate Cuts

The Federal Reserve, in its meeting, slashed key interest rates by 50 bps to 4.75%-5% after holding it at a 23-year high for 14 consecutive months since July 2023. This marked the first rate cut since 2020 to address slowing economic growth and showed greater confidence in the fact that inflation is moving sustainably toward the 2% target level. 

The central bank projects two more rate cuts of another 50 bps in its final two meetings this year, due in November and December. It indicates another 100-bps rate cut next year and 50-bps in 2026, which means four rate cuts in 2025 and two in 2026 (read: 5 ETF Zones Set to Benefit When Fed Initiates Rate Cuts).

The rate cut is “a welcome development” and should put the stock market on good footing going forward. While the rally will be broad-based, small-caps will tend to outperform. This is because small caps collectively rely more on external financing than their larger-cap peers, and therefore, falling borrowing costs are a tailwind.

We have highlighted five ETFs from the space having a Zacks ETF Rank #1 (Strong Buy) or #2 (Buy). These are Vanguard Small-Cap ETF VB, iShares Russell 2000 ETF IWM, Vanguard Small-Cap Growth ETF VBK, JPMorgan BetaBuilders U.S. Small Cap Equity ETF BBSC and iShares Morningstar Small-Cap Growth ETF ISCG. These funds have gained momentum lately on Fed rate cut bets and will likely continue their trend post the cut.

Why Small-Caps?

The pint-sized companies have a higher debt burden, mostly at floating rates. Lower rates lead to reduced borrowing costs, which helps small businesses to expand their operations easily and results in increased profitability. This, in turn, stimulates economic growth. As small-cap companies are more domestically tied, these are poised to outperform when the economy improves.

Rate cuts coupled with attractive valuations of small caps make it an interesting asset class for investors at the current levels. After years of lackluster performance, U.S. small caps look attractively valued both on a historical basis and relative to U.S. large caps. U.S. small caps currently trade at the largest discounts relative to U.S. large caps since the dot-com bubble, according to some measures. Per WSJ data, the small-cap index Russell 2000 is currently trading at a P/E ratio of 24.36 compared to 30.80 for the NASDAQ 100 Index and 25.78 for the Dow Jones (read: 5 Stocks Fueling Nasdaq ETF's Best Week in 2024).

Additionally, the artificial intelligence (AI) craze holds the promise of ushering in fresh growth opportunities in every corner of the small-cap space. While mega-cap companies are leading the AI world, many small-cap stocks having huge potential in this field remain untapped. According to a new report by Grand View Research, the global artificial intelligence market is expected to witness a CAGR (2024-2030) of 36.6% to reach $811.75 billion by 2030.

Furthermore, small-cap stocks are considered safer and better plays if political issues or economic turmoil creep into the picture. Escalating tensions in the Middle East and the ongoing Russia-Ukraine war are driving the appeal for small-cap stocks, which are closely tied to the U.S. economy.

ETFs to Gain

Vanguard Small-Cap ETF (VB) 

Vanguard Small-Cap ETF follows the CRSP US Small Cap Index and holds a basket of 1,400 stocks, with none holding more than 0.5% of assets. Vanguard Small-Cap ETF is widely spread across various sectors, with industrials, consumer discretionary, financials, information technology and healthcare being the top five.

Vanguard Small-Cap ETF has AUM of $59.4 billion and trades in a solid average daily volume of about 667,000 shares. VB charges 5 bps in fees per year from investors. 

iShares Russell 2000 ETF (IWM)

iShares Russell 2000 ETF is the largest and most popular ETF in the small-cap space, with an AUM of $69.6 billion and an average daily volume of 33 million shares. It tracks the Russell 2000 Index and holds well-diversified 1,973 stocks in its basket. IWM has key holdings in financials, healthcare, industrials and information technology.

iShares Russell 2000 ETF charges 19 bps in annual fees (read: Will Small-Cap Stocks Continue to Outperform?).

Vanguard Small-Cap Growth ETF (VBK)

Vanguard Small-Cap Growth ETF tracks the CRSP US Small Cap Growth Index, holding 624 stocks in its basket. From a sector look, technology takes the top spot at 31% while industrials, healthcare, and consumer discretionary round off the next three spots, with double-digit exposure each. 

The product has amassed $17.6 billion in its asset base while trading in a solid volume of around 305,000 shares. It charges 7 bps in fees per year.

JPMorgan BetaBuilders U.S. Small Cap Equity ETF (BBSC) 

JPMorgan BetaBuilders U.S. Small Cap Equity ETF provides exposure to the small-cap U.S. equity market using an indexed approach. It follows the Morningstar US Small Cap Target Market Exposure Extended Index and holds 788 stocks in its basket. JPMorgan BetaBuilders U.S. Small Cap Equity ETF has key holdings in financials, industrials, health care, information technology and consumer discretionary.

JPMorgan BetaBuilders U.S. Small Cap Equity ETF has AUM of $523.2 million and trades in an average daily volume of 5,000 shares. It charges 9 bps in fees per year. 

iShares Morningstar Small-Cap Growth ETF (ISCG)

iShares Morningstar Small-Cap Growth ETF provides exposure to small public U.S. companies whose earnings are expected to grow at an above-average rate relative to the market. It follows the Morningstar US Small Cap Broad Growth Extended Index and holds 997 stocks in its basket. Industrials takes the largest share at 21.4% of the assets while information technology, healthcare and consumer discretionary round off the next spots.

iShares Morningstar Small-Cap Growth ETF has amassed $590.9 million in its asset base and trades in a good average daily volume of around 40,000 shares. It charges 6 bps a year from investors.
 

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