In no uncertain terms, the S&P 500 Index's performance in the first half of 2024 was driven by select members of the Magnificent Seven: Nvidia, Amazon, Microsoft, and Alphabet; as they have become proxies of the 'Artificial Intelligence' theme, benefitting from the surrounding enthusiasm. As illustrated in the following chart, the S&P 500 returned 15.3%, and 8.0% of that 15.3% return was derived by Nvidia, Amazon, Microsoft, and Alphabet. The rest of the index provided the remaining 7.3% return.

Small-Cap Stocks: A Potential Winner as Interest Rates Decline

While the growing concentration and influence of big tech names within the U.S. equities asset class have been cause for concern, the macroeconomic backdrop is currently changing. U.S. inflation is coming down, consumer spending is still strong, and growth is moderating but not stalling.

The supportive nature of this incoming data has led to a heightened possibility of a rate reduction occurring in September 2024, as indicated by Federal Reserve Chair Jerome Powell's recent statements, "The time has come for policy to adjust" in Friday's keynote speech at the Kansas City Fed's annual economic symposium in Jackson Hole, Wyoming.

Small-cap equities are among the asset classes poised to benefit from an improving economy and a foreseeable drop in interest rates. Small-cap firms typically have less access to credit and are more sensitive to changes in interest rates. According to research conducted by Goldman Sachs, 30% of Russell 2000 company debt is floating rate as opposed to 6% for S&P 500 company debt. This combination causes small-cap companies to typically have higher debt levels and lower credit ratings than large-cap companies.

Consequently, small caps rely more on bank loans, which usually have floating rates, whereas large caps tend to use bond financing with fixed maturities. As interest rates have risen, this financing structure has become more challenging for small-cap companies. Ergo, the fall in interest rates will be advantageous to small-cap companies.

In the second half of 2024, U.S. small-cap equities began to exhibit compelling performance relative to large and mid-cap equities, as there has been a gradual rotation toward small-cap equities in anticipation of an interest rate reduction. As illustrated in the following chart, the performance of small-cap equities thus far into the second half of 2024 has been strong.

Investing U.S. Small-Cap Equities with ETFs

There are a few notable ETFs available for investors looking to gain exposure to the U.S. small-cap asset classes. It should be noted that active management is beneficial in navigating this particular asset class, as choosing the right company based on quantitative and qualitative factors can have a material impact on performance. Conversely, a passive approach would allow for the exposure of unprofitable companies. Furthermore, small caps have lower cross-sectional correlation and higher cross-sectional volatility, which gives active stock pickers greater optionality within their opportunity set.

For investors looking for U.S. small-cap equity ETFs, the below are worthy of consideration:

TD Q U.S. Small-Mid-Cap Equity ETF (Ticker: TQSM) seeks to achieve long-term capital growth by using a quantitative approach to security selection to invest primarily in, or gain exposure to, equity securities of small or medium-sized issuers in the United States. The quantitative equity strategy will generally result in a portfolio of investments in many securities broadly diversified across all sectors. Furthermore, the strategy aims to optimize exposure to stocks expected to outperform the overall market while factoring in implementation costs and seeking to avoid uncompensated risks.

As of August 23, 2024, the year-to-date performance of the ETF is 13.35%

BMO S&P US Small Cap ETF (Ticker: ZSML) has been designed to replicate the performance of the S&P SmallCap 600® Index. The ETF invests in and holds the Index's constituent securities in the same proportion as they are reflected in the Index.

As of August 23, 2024, the year-to-date performance of the ETF is 10.19%.

iShares S&P U.S. Small Cap Index ETF (Ticker: XSMC) has been designed to replicate the performance of the S&P SmallCap 600® Index. The ETF invests in and holds the Index's constituent securities in the same proportion as they are reflected in the Index.

As of August 23, 2024, the year-to-date performance of the ETF is 10.83%.

Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.