Will Small-Cap ETFs be Able to Sustain the New-Found Optimism?

After a long period of underperformance, small-cap U.S. stocks may be staging a comeback. While it's too early to say for sure whether this is the start of a sustained rally or just an occasional rise, recent data shows encouraging signs for small-cap investors.

Small-cap exchange-traded fund iShares Russell 2000 ETF IWM has gained 6.3% over the past month (as of Sept. 3, 2025) versus about 2% gains in SPDR S&P 500 ETF Trust SPY. However, IWM still lags SPY when the year-to-date performance is considered. So far this year, SPY is up about 10% while IWM has advanced about 5.7%.

Much of the early-year weakness in small caps was caused by President Trump’s announcement of higher tariffs in April, which hit smaller companies hard.

Fed Rate Cut Bets to Fuel Small-Cap Buying?

Bank of America’s client flow data revealed near-record demand for small-cap stocks in the past week, following Federal Reserve Chair Jerome Powell’s hint of an upcoming rate-cutting cycle at Jackson Hole, WY, as quoted on CNBC.

Clients at the firm purchased $1.5 billion worth of small and micro-cap single stocks along with small-cap ETFs over the past week. This marked the second-largest weekly inflow since 2008, the above-mentioned CNBC article reflected.

The Fed will likely cut interest rates in September. There are 97.6% (at the time of writing) chances of a 25-bp rate cut in September, per the CME FedWatch Tool. A softer labor market will probably lead the Fed to consider this path. The start of the monetary easing cycle (if there is any) is a great plus for small-cap stocks and ETFs.

What Does the Earnings Picture Say?

For the small-cap S&P 600 index, we now have Q2 results from 586 index members. Total earnings for these companies are up 8.6% from the same period last year on 3.4% higher revenues, with 61.1% beating EPS estimates and 72.4% beating revenue estimates, as quoted on the Earnings Trends issued on Sept. 3, 2025.

Note that total earnings for the 493 S&P 500 companies that have reported already are up 12.4% from the same period last year on 6.0% higher revenues, with 79.9% beating EPS estimates and 78.7% exceeding revenue estimates.

The above comparison shows that the small caps are trying to catch up on the growth front, although still lagging their large-cap peers. However, the tide could be turning in favor of small-cap stocks, though it is too early to say. Investors should be watching closely to see this long-ailing segment.

What Does Small-Cap Stock Valuation Say?

Per WSJ data, the Russell 2000 is currently trading at a P/E ratio of 32.75 (as of Aug. 29, 2025), versus the year-ago level of 27.79. The Russell 2000 is trading almost on par with the Nasdaq 100.

The Nasdaq 100 Index is trading at a P/E ratio of 32.97X, above the year-ago level of 31.17X, per the Wall Street Journal. In comparison, the S&P 500 Index traded at a P/E ratio of 25.15, up from the year-ago level of 23.96. It shows that small caps are not cheap, if not extremely overvalued.

Mixed Economic Outlook: A Weak Point?

U.S. GDP grew 3.3% in the second quarter of 2025, marking a revival from the 0.5% slump in Q1, per AP, as quoted on Yahoo Finance. The initial government data indicated an expansion of 3% for Q2 of 2025.

Consumer spending (which makes up about 70% of the U.S. GDP) and private investment were a bit stronger-than-initially-expected in the second quarter, as quoted on APNews.com.

Meanwhile, U.S. Labor Department data showed on Sept. 3, 2025, that job openings, a measure of labor market demand, fell more than expected to 7.181 million in July. Economists polled by Reuters had expected 7.378 million job openings in the JOLTS data, as quoted on Mint.

If the U.S. economy starts showing signs of weakness, small caps are likely to underperform, as these stocks are mostly domestically tied and have lesser export exposure.

Time to Consider Value in Small Caps?

Against this backdrop, below we highlight a few winning small-cap exchange-traded funds. Note that value and blend small-cap ETFs outperformed the growth ones over the past month (as of Sept. 2, 2025).

Invesco S&P SmallCap 600 Pure Value ETF RZV – Up 11.0% Past month

Invesco S&P SmallCap Value with Momentum ETF XSVM – UP 9.9% Past month

iShares US Small Cap Value Factor ETF SVAL – Up 9.1% Past month

 First Trust Small Cap Core AlphaDEX ETF FYX – Up 7.8% Past month

Invesco S&P SmallCap 600 Revenue ETF RWJ – Up 8.7% Past month

Fidelity Enhanced Small Cap ETF FESM – Up 7.4% Past month

One of the top performers in the growth space has been First Trust Small Cap Growth AlphaDEX ETF FYC, which has surged 7.7% over the past month. Several other small-cap growth ETFs, too, failed to offer as sturdy gains as value funds offered. Note that value ETFs offer protection to a portfolio in sudden market swings. 

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This article originally published on Zacks Investment Research (zacks.com).

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