It's almost universally agreed the Federal Reserve will cut short-term rates in September. And ETF investors are shifting portfolios to take advantage.
ETFs that invest in small stocks — especially value-priced ones — have rallied in the past month versus the S&P 500, says Morningstar Direct. Eight of the top 10 returning U.S. diversified ETFs in the past month are small-stock ETFs.
The best performer of the bunch, Invesco S&P SmallCap Quality ETF returned nearly 7% over the past four weeks as of Aug. 26. That easily tops the 1.3% one-month return of the S&P 500.
"With expectations of pending interest rate cuts, the style has returned to favor," said Todd Rosenbluth of TMX Vetta Fi. "Small-cap companies tend to incur more debt and can benefit from lower rates. Value companies can benefit when the Fed stimulates the economy."
Gearing Up For Lower Rates
Small caps are starting to perk up at historic levels. And investors are taking note.
On Aug. 22, the market "saw the small-cap Russell 2000 experience the strongest single-day breadth reading since April and a top-percentile move relative to all days since 2010," said Bespoke Investment Management. The breadth reading measures the percent of index members to join the rally.
Typically, such a move is bullish for the future. Bespoke found small-cap stocks gained an additional 22% following such high breadth readings. Small caps in the health care sector are especially strong, Bespoke found.
But health care isn't the only sector pulling up small-cap ETFs. Industrial stocks are the largest position in the $291.2 million-in-assets Invesco S&P SmallCap Quality ETF, at 22.9%. The ETF's largest holding out of 120 positions is Sterling Infrastructure at 2.7%. It's a construction firm that focuses on large civil projects.
Know What You Own
Given the massive pool of small-cap stocks, it's important to remember the ETFs in the space can vary wildly from one another.
That's especially true when an ETF zeros in on value-priced stocks. Value is often in the eye of the beholder. "There are differences in index based small-cap value ETFs based on what is considered a small company and what stocks have value traits," Rosenbluth says. He points to two small value ETFs, iShares S&P Small-Cap 600 Value ETF and iShares Russell 2000 Value ETF, as examples.
The $6.6 billion-in-assets IJS holds 459 positions with the largest being home loan servicer Mr. Cooper Group at 1.8%. Meanwhile, the $11.6 billion-in-assets IWN holds more than 1,400 positions with bank UMB Financial at the top with a 0.6% weighting.
And the sector variances are even greater. "IWN recently had double the exposure to energy stocks than IJS," Rosenbluth said.
What's Next For Small Stocks
Some, like Nicholas Colas of DataTrek Research, have awaited the small-cap rally due to the expectation of an interest-rate cut. But Colas thinks that bullish news is now priced in.
"The (small cap) Russell 2000 has outperformed the (large cap) S&P 500 over the last 100 days, an unusual occurrence in the 2023 to present bull market," he said. "We've been calling for this move but, without a fresh catalyst, we are concerned it may fade over the next 100 days."
Specifically, he points out "despite small caps being riskier than large caps, their average 100-day relative performance has been consistently negative." Recently when small caps pull ahead of the S&P 500, they usually fade.
And so small caps, especially value, will need more gains to win over investors loaded up with large caps. "Many investors have ignored the style as it lagged behind. While small cap ETFs are more likely to have modest positions in a broadly diversified portfolio, those with a value and not a growth tilt have largely been ignored," Rosenbluth said.
Top-Returning Small Cap ETFs Thrive
| Name | Ticker | One-month return % | Assets, $ billions |
|---|---|---|---|
| Invesco S&P SmallCap Quality | XSHQ | 6.82% | $0.29 |
| Invesco S&P SmallCap Value with Momentum | XSVM | 6.72 | 0.58 |
| Fidelity Enhanced Small Cap | FESM | 6.61 | 2.20 |
| Invesco S&P SmallCap Momentum | XSMO | 6.17 | 1.85 |
| Renaissance IPO | IPO | 6.11 | 0.16 |
| EA Bridgeway Omni Small-Cap Value | BSVO | 5.67 | 1.69 |
| Avantis US Small Cap Equity | AVSC | 4.92 | 1.87 |
| iShares S&P Small-Cap 600 Value | IJS | 4.76 | 6.56 |
| Vanguard S&P Small-Cap 600 Value | VIOV | 4.73 | 1.38 |
| SPDR S&P 600 Small Cap Value | SLYV | 4.72 | 4.02 |
