Interest rate cuts historically benefit equities, resulting in outperformance for the next year after the initial rate cut. Pockets of more pronounced opportunity may exist within stocks for investors in a declining rate environment. Consider small-caps and the real estate and financial sector when harnessing rate-sensitive rebound potential.
Rebound Potential of Small-Caps
Small-cap companies generally are more rate-sensitive than their larger market capitalization peers. With smaller funding pools, they often have greater debt and rely more heavily on the markets to raise money than large-cap companies. While this means they feel the squeeze first in a rising rate environment, they also historically benefit first as rates decline.
The valuation gap between small caps and large caps also remains notable as of the end of August. The Russell 2000 Index, which includes 2,000 of the smallest U.S. companies by market cap, offered a trailing price-to-earnings (minus negative earnings) ratio of 17.75 according to the FTSE Russell as of 8/31/24. The P/E ratio is calculated by dividing a company’s current stock price by its annual earnings per share.
In comparison, the Russell 3000 Index, which accounts for 98% of the investable U.S. equity market, had a price-to-earnings (minus negative earnings) ratio of 25.66 over the same period. This leaves small-cap stocks with the possibility for a longer runway and greater rebound potential than large-cap stocks as interest rates fall.
Fidelity offers several funds for investors looking to capture the potential in small-caps and rate-sensitive sectors. Within small-caps, Fidelity Enhanced Small Cap ETF (FESM) is actively managed and seeks to outperform the Russell 2000 Index. The strategy, a mutual fund conversion, uses a proprietary systematic model when selecting securities. The analysis evaluates securities across factors such as quality, valuation, and growth alongside a tailored risk model to manage benchmark deviation and promote a core equity exposure.
See also: “Fidelity Offers Core Equity Exposure with Active Benefits”
Meanwhile, Fidelity Small-Mid Multifactor ETF (FSMD) offers exposure to small- and midcap stocks in a passive, transparent, and rules-based manner. Companies held by the fund are high-quality, have an attractive valuation profile alongside positive momentum, and exhibit reduced volatility compared to the broad market.
Sectors That Benefit From Rate Cuts
While many sectors may benefit from declining interest rates, the real estate and financial sectors generally have more rate sensitivity. Similar to small caps, both sectors currently have low valuations with room to catch up.
What’s more, both the financial and real estate sectors spent much of this year lagging other sectors. It’s a somewhat anomalous trend, as these sectors generally begin to recover ahead of rate cuts.
For advisors and investors seeking targeted sector allocation, Fidelity offers a suite of sector ETFs. Investors looking to add exposure to the real estate sector don’t want to miss Fidelity MSCI Real Estate Index ETF (FREL). The fund seeks to track the MSCI USA IMI Real Estate Index using a representative sampling strategy. This means the strategy may invest in some, but not all, of the securities of the index. It does so while maintaining the fundamental characteristics of the index, including market cap, weighting, returns, and liquidity.
For those with an eye toward income within real estate, Fidelity Real Estate Investment ETF (FPRO) is worth consideration. The fund is actively managed, a potential boon in a dynamic rate environment. It seeks above-average income and long-term capital growth while balancing for risk. The strategy offers exposure to major real estate investment themes and considers an issuer’s industry position, financial health, and the market and economic environment when stock selecting.
Similarly to FREL, Fidelity MSCI Financials Index ETF (FNCL) offers exposure to the financial sector. The fund seeks to track the MSCI USA IMI Financials Index using a representative sampling strategy.
For more news, information, and strategy, visit the ETF Investing Channel.
Fidelity Investments® is an independent company unaffiliated with VettaFi LLC (“VettaFi”). These articles do not form any kind of legal partnership, agency affiliation, or similar relationship between VettaFi and Fidelity Investments, nor is such a relationship created or implied by the articles herein. VettaFi LLC is the author and owner of these articles.
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