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The US Federal Reserve has finally embarked on the rate-cutting cycle. Lower interest rates can benefit small-cap stocks by improving borrowing conditions, increasing investor risk appetite, and offering the potential for outperformance.
Markets also expect US President Donald Trump to likely relaunch the high external tariffs and low domestic corporate taxes policies seen during his first presidency, which will further serve as a tailwind for small- and mid-cap businesses.
However, investing in small-cap stocks carries higher volatility and bankruptcy risks. Diversification and research are crucial. What could be an investment strategy for individual investors tipping their toes into smaller-cap stocks amid the current macroeconomic backdrop in 2025?
Read more: What are small-cap stocks?
Small-caps and interest rate moves
Small-caps typically have a larger debt burden with a larger proportion of their debt in floating-rate debt, thereby they are more exposed to higher interest rates.
One in three companies in the Russell 2000 are financed with floating rates, compared to only 6% of companies in the S&P 500 Index. This has led to small caps generally having higher debt and lower credit ratings than their large-cap counterparts. As rates increased in 2021, the financing structure presented a greater challenge to the small cap space. Therefore, a rate cut could lower borrowing costs and could positively impact small-cap companies.
Comparing the debt structure of the large- and small-cap companies
Historically, small-caps have outperformed in lower interest rate environments. The Russell 2000 has typically performed well in the past when the Fed policy shifts to interest rate cuts from rate hikes. Over the five Fed rate-cutting cycles since 1990, on average the Russell 2000 has outperformed the S&P 500 by 700 basis points in a 12-month period following the rate cuts.
Are small-cap stocks undervalued?
Looking at small-cap stock valuations, based on a 12-month forward price to earnings, it’s clear that small caps are currently undervalued and out of favour amongst investors. As of September 2024, small caps are trading at significant discounts compared to large caps and are below their long-run averages. This could indicate potential catch-up trade once the environment is more suitable.
Valuations of small-cap stocks
How do small caps fit into a portfolio?
Especially after the past decade of strong mega-cap performance, a large proportion of investors' equity portfolios will be invested in large-cap stocks.
Quality small and mid-cap stocks should offer not only the prospect for long-term growth, but also the potential portfolio diversification benefits from investing across the market-cap spectrum. Current valuations for these firms, coupled with an environment of improving earnings-per-share growth could lead to a wider range of these companies delivering competitive returns.
Small-cap equity funds on Endowus Fund Smart
Investors looking to participate in the growth of small-caps can consider these funds as a satellite allocation. Out of the top mutual funds, a carefully curated selection of small and mid-cap equity funds is available on the Endowus Fund Smart platform.
T. Rowe Price US Smaller Companies Equity Fund
ISIN: LU0133096635 (USD)
Long-standing US small and mid-cap strategy that is style neutral with broad exposure to both growth and value small and mid-cap companies.
As a firm, T. Rowe Price is one of the pioneers in small-cap investing with more than US$70 billion in AUM in small-cap equity funds. The firm has been managing US small-cap strategies since 1960.
The strategy behind the T. Rowe Price US Smaller Companies Equity Fund was launched in 2001 and has outperformed its benchmark since inception with stock selection driving the outperformance. The fund’s approach is underpinned by a disciplined, bottom-up stock selection process, leveraging the extensive experience of more than 70 fundamental analysts for deep market insights.
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Fidelity - Global Discovery Fund
ISIN: LU2755903395 (USD)
The Global Discovery fund's investment philosophy and process is based on Fidelity Investment’s Low-Priced Stock strategy, which was launched in 1989 and has more than US$37 billion in assets.
Strong value and quality focus with an opportunistic approach focused on companies across the market cap spectrum, including the small and mid-cap universe of stocks. The resulting portfolio has between 450 and 600 names to allow them to opportunistically invest in smaller companies despite the strategy size. The Fund leverages Fidelity’s depth & breadth of investment resources in uncovering gems across the market cap spectrum globally, including small- and mid-cap companies that tend to be under-researched with strong growth potential.
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*Five-year returns are based on the period from September 2019 to October 2024 unless otherwise stated. Returns in USD and are net of fund-level fees. Annualised returns are calculated based on the returns of the target share class, and the oldest strategy of the fund (Fidelity® Low-Priced Stock Fund). Returns are in USD.
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Complex Products
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