Are Small-Cap ETFs Finally Ready to Shine?

The small-cap space has started to show momentum in recent weeks. The ultra-popular iShares Russell 2000 ETF IWM gained nearly 3% over the past week, outpacing the gain of 1% for the broad market fund SPY.

There are various factors that are supporting the small-cap rally and will continue to do so in the short term.

Anticipated Fed Rate Cuts

The latest inflation data has increased expectations for a rate cut in September. Per the CME Group, futures markets were pricing in a 94% chance of a quarter-point cut at next month’s Fed meeting, compared with about 85% before the inflation data (read: Small-Cap ETFs Outperform on Inflation Data).

As pint-sized companies have a higher debt burden (mostly at floating rates), lower rates lead to reduced borrowing costs, helping small businesses expand their operations easily and resulting in increased profitability.

Underperformance & Attractive Valuations

The Russell 2000 (small-cap benchmark) trails the S&P 500 from a year-to-date look, up just 1.5% versus 9.6%. This underperformance may offer an advantageous entry point, especially with BofA signaling long-term optimism for small and mid-cap sectors amid overvalued large caps.

As such, small-caps are trading at a discount compared to large-caps, offering a valuation edge. Institutional investors are increasingly rotating out of crowded mega-cap trades into undervalued segments like small-caps, a trend that has accelerated in recent weeks.

Growing Small-Business Optimism

Optimism among small business owners grew in July on better business conditions and expansion opportunities. The latest data from the National Federation of Independent Business (NFIB) revealed that the small business optimism index climbed to 100.3 in July — the highest level since February and slightly above the 52-year average of 98. Small businesses serve as a vital barometer of the U.S. economy. The rise in optimism could reflect a stabilizing business environment, offering a bullish signal for market sentiment and boding well for small-cap stocks and ETFs.

Reshoring & M&A Trends

Onshoring and reshoring trends favor domestically focused small-cap firms, especially as global supply chain vulnerabilities persist. Companies bringing supply chains back to the United States stand to benefit domestic-focused small-cap firms (read: Small-Cap ETFs Rally in July: Will the Momentum Continue?).

Dealmaking is picking up in healthcare, biotech and tech services. Large-cap companies with ample cash are targeting small and mid-sized firms for growth, given their innovative edge and lean valuations. This M&A momentum is drawing active managers and hedge funds, injecting fresh liquidity into the space. M&A activity historically favors small companies (90% of acquired firms are small caps) and this trend is expected to continue as larger firms seek growth.

AI & Crypto Tailwinds

AI-driven infrastructure growth (e.g. data centers, cooling, electrification) may lift niche small-cap segments.

Broadening Market Breadth

While mega-cap stocks have led the rally in recent years, gains are beginning to spread more evenly across the market. This broadening trend often signals healthier market dynamics and can act as a catalyst for small-cap outperformance.

Top Zacks Rank ETFs to Buy

There are several ETFs in the space with a solid Zacks ETF Rank #1 (Strong Buy) or #2 (Buy), suggesting their outperformance in the coming weeks. Some of these are iShares Core S&P Small-Cap ETF IJR, Vanguard Small-Cap ETF VB, Schwab U.S. Small-Cap ETF SCHA, Vanguard Russell 2000 ETF VTWO, SPDR Portfolio S&P 600 Small Cap ETF SPSM, and Vanguard S&P Small-Cap 600 ETF VIOO. These funds are well diversified across various sectors and securities.
 

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This article originally published on Zacks Investment Research (zacks.com).

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