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Study small-cap stocks long enough and you are likely to learn a few things, one of which is this corner of the equity market is often sensitive to changes in interest rates. That’s a big reason why the Russell 2000 index tumbled 21% — a bear market — in 2022 when the Federal Reserve started boosting rates.
Fortunately for small-cap investors, the Fed is turning accommodative and the consensus on Wall Street holds that September’s rate cut will be followed by another next week. That stokes upside for exchange-traded funds (ETFs) such as Avantis U.S. Small Cap Value ETF (NYSEMKT: AVUV).
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Let’s explore why AVUV could be awesome against the backdrop of declining interest rates.
This $18.31 billion fund turned six years old last month and prospective investors should note it is an actively managed ETF, meaning there’s a human-led team of pros overseeing the fund on a day-to-day basis. So it’s possible that the team can adjust the portfolio to better capitalize on declining interest rates.
AVUV could be an October ETF darling if the Fed cooperates. Image source: Getty Images.
AVUV’s managers might not have to do much adjusting because smaller stocks are already more sensitive to the economic cycle than their large-cap peers. Remember the Fed is paring rates in an effort to prop up the U.S. economy and if that gambit proves effective, small-cap ETFs such as AVUV could be primed for outperformance if the economy gains momentum.
Another reason small caps, including AVUV constituents, could shine if the U.S. economy gains steam is because these companies generate higher percentages of domestic sales than large-cap companies. Some AVUV member companies may count on their home country for the bulk, if not all of their sales, tethering them to the strength (or weakness) of the U.S. economy.
A significant part of a solid foundation of ETF education is knowing what you own. Yes, AVUV tells investors it’s a small-cap value fund, but there are more chapters in this book, particularly as it pertains to Fed policy.
Not all sectors respond to Fed easing in linear fashion. Some could derive larger rate cut benefits than others. For example, an accelerating economy and reduced financing costs could be catalysts for sectors such as energy, financial services, and industrials — groups that combine for 59% of the AVUV portfolio as of Sept. 30.
Based on its sector exposures, AVUV could be a near-term winner because, broadly speaking, growth stocks tend to outperform value names when rates are falling. Obviously, AVUV is a value fund, but its sector weights could help it command more-than-adequate rate cut benefits.
One of the biggest reasons small caps often benefit from Fed easing is their dependence on external financing. These companies need to raise capital to nurture their businesses, but with so many not yet profitable, the cost of financing can be high, particularly when rates are elevated. In fact, more than 40% of Russell 2000 members are unprofitable companies.
As an actively managed ETF, AVUV can avoid some of those money-losers while still catching a tailwind if “junk” small caps experience a Fed-induced rally.
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Todd Shriber has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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