During the Federal Reserve's interest rate reduction cycle, small-cap stocks may be one of the categories that the market pays more attention to.

This article discusses how to invest in small-cap stocks in the US market under the expectation of interest rate cuts.

Why have small-cap stocks underperformed in 2024?

In the stock market, investors often classify stocks according to their market capitalization.

Generally speaking, stocks with a market cap between 0.25 billion and -2 billion USD are called small-cap stocks, while those with a market cap over 10 billion USD are referred to as large-cap stocks.

Investors distinguish between small-cap and large-cap stocks because these two categories of stocks have very different characteristics.

Large-cap stocks are typically large, established companies with relatively low growth potential but strong stability. In contrast, small-cap stocks represent smaller companies with greater growth potential but also come with higher risks.

In the US stock market, the E-mini Russell 2000 Index is the most commonly used indicator tracking the overall performance of small-cap stocks.

So far this year, the E-mini Russell 2000 Index, which represents small-cap stocks, has performed modestly, with an increase of only 0.15% year-to-date, significantly underperforming the S&P 500 Index by 14.61%. Morningstar's Analysts believe that persistently high interest rates and the market's enthusiasm for AI stocks are the reasons for the poor performance of small-cap stocks.

The case is for illustrative purposes only and does not constitute any investment advice or guarantee.

Could small-cap stocks benefit from the Federal Reserve's interest rate cuts?

Generally, in an environment of interest rate cuts, small-cap stocks may benefit more than large-cap stocks, mainly because small-cap stocks are more sensitive to interest rate cuts.

Many small companies are more reliant on debt compared to large enterprises. Interest rate cuts lower borrowing costs, which means that for small companies that depend on bank loans and variable-rate debt, their financial costs decrease, thereby improving profit margins.

So how do small-cap stocks perform historically in an environment of interest rate cuts? Investors can glean insights from the performance of small-cap stocks after the Fed has started cutting rates historically.

According to a report by Reuters, Jefferies analyzed data since 1950 and found that small-cap stocks outperformed large-cap stocks after the Federal Reserve's first interest rate cut.

After the Federal Reserve's first interest rate cut, small-cap stocks increased by 11%, 15%, and 28% over 3, 6, and 12 months respectively, all higher than the large-cap stocks' increases of 5%, 10%, and 15%.

It can be seen that the impact of interest rate cuts on small-cap stocks may be more pronounced.

How to invest in small-cap stocks?

There are two ways to invest in small-cap stocks: one is to dig for quality stocks with potential, and the other is to invest in the entire sector through ETFs.

Investors can use Futubull to check the constituents of the E-mini Russell 2000 Index, and then find quality potential stocks through industry outlook, company finances, company valuation, and other indicators.

The following are the top ten constituents of the E-mini Russell 2000 Index ranked by market cap. Among them, the top three by market cap are AI popular stock Super Micro Computer ($Super Micro Computer(SMCI.US)$), Bitcoin concept stock MicroStrategy ($Strategy(MSTR.US)$) and second-hand car dealer Carvana ($Carvana(CVNA.US)$）。

Source: Futubull. Data is as of the close on July 1, 2024. The case is for illustrative purposes only and does not constitute any investment advice or guarantee.

Although investors can dig for quality individual stocks themselves, investing in only one particular stock can be very risky, so it is best to diversify risks. To achieve this, the best method is to cover a sufficient number of small stocks as well as a sufficient number of Industries.

Therefore, indirectly investing in small stocks through small stock ETFs is a good choice, eliminating the hassle of stock selection.

In the US stock market, the E-mini Russell 2000 Index is one of the most popular small stock indexes, and there are many ETFs tracking the E-mini Russell 2000 Index, among which the largest one is$iShares Russell 2000 ETF(IWM.US)$. In addition, there are leveraged ETFs and inverse ETFs tracking the E-mini Russell 2000 Index, such as$Proshares Trust Pshs Ultruss2000(UWM.US)$which is a 2x leveraged long ETF, while$Direxion Daily Small Cap Bull 3X ETF(TNA.US)$is a 3x leveraged long ETF.

However, it must be noted that while leveraged ETFs can achieve excess returns, they can also magnify losses, and leveraged ETFs may have decay, so investors should pay special attention when making their choices.

Here is a compilation of ETFs that track the E-mini Russell 2000 Index (including leveraged and inverse ETFs) for everyone's reference.

Risks of investing in small-cap Stocks.

1. High volatility: Compared to large-cap Stocks, small-cap Stocks are often more unstable, with many companies still not profitable. In other words, the E-mini Russell 2000 Index usually experiences greater fluctuations than the major indices, thus presenting relatively higher risks.

2. Low representation of the Technology Industry: The E-mini Russell 2000 Index covers a diverse range of industries, mainly concentrated in areas such as industrials, finance, healthcare, and consumer discretionary. Compared to other large-cap Stock indices, the Technology Industry has a relatively small weight within it. However, the Technology Sector is currently one of the hottest industries in the market, such as artificial intelligence, cloud computing, and semiconductors. If future investments continue to focus on Technology themes, the E-mini Russell 2000 Index may miss out on the benefits of the Technology Sector's rise.

Risk Disclosure: This content does not constitute a research report and is for reference only, not to be used as a basis for any investment decision. The information included herein is not a comprehensive description of the securities, markets, or developments mentioned. Although the sources of information are considered reliable, there is no guarantee of the accuracy or completeness of the above content. Furthermore, there is no guarantee of the accuracy of any statements, opinions, or predictions provided in this article.