2 Hassle-Free ETFs to Buy Before the Fed Cuts Interest Rates

We’ve been waiting for over a year for the Federal Reserve to make its next move on interest rates. It seems the time has finally arrived.

After a historic rate hike campaign in 2022 and 2023 to help curb inflation, the Fed has held rates steady since last August. Chairman Jerome Powell said the Federal Open Market Committee (FOMC) is waiting for data to confirm whether the economy is on a path toward its annual inflation target of 2 percent. At the most recent FOMC meeting in July and at the Jackson Hole conference in August, Powell indicated a strong likelihood of rate cuts in September.

While the Federal Reserve is concerned with its dual mandate of steady inflation and full employment, its actions can have a significant impact on investors. While markets are always forward-looking, pricing in expectations, there is still a long way to go for the Fed to cut rates, according to its own projections. That means there are still opportunities for investors.

These two exchange-traded funds (ETFs) look like great options ahead of the Federal Reserve’s impending rate cuts.

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1. A small-cap value fund

Smaller companies are much more sensitive to interest rates than larger companies. An interest rate cut provides significant relief for small businesses carrying debt. This is especially true if that debt is floating rate debt instead of a long-term corporate bond, which is more common among smaller companies.

It’s not just small-cap, money-losing, early-stage growth stocks that rely on debt. Many well-established and profitable companies use debt to maintain liquidity and finance future growth. And those companies could offer one of the best investment opportunities as the Fed cuts interest rates.

Small-cap value stocks have historically produced better returns than any other segment of the market over the long term. However, over the past few years, they have seriously lagged large-cap stocks as the Fed has raised rates and tightened the money supply. That trend could be about to reverse as the Fed cuts interest rates.

One of the best ways to invest in small value stocks is with Avantis US Small Cap Value ETF (AVUV -1.67%). Technically, an actively managed fund aims to outperform Russell 2000 value Index. The fund selects stocks based on book value and profitability, investing in hundreds of small-cap stocks based on its criteria. When a stock no longer meets the criteria, it is sold and new stock is added if and when it meets the criteria.

This active selection and passive implementation has worked extremely well while keeping the fund’s expense ratio relatively low. Investors pay just 0.25% of assets per year, slightly above small-cap equity index funds but well below the average actively managed fund.

There are several other factors favoring small-caps right now, including low valuations relative to large-caps and a return to money supply growth (which will accelerate as interest rates fall). Buying the Avantis ETF is one of the smartest ways to play the Fed’s upcoming rate cuts.

2. A long-term treasury bond fund

Another way to invest in lower interest rates is to buy government bonds. Locking in currently high rates could yield strong results as the government issues new bonds at lower rates. When this happens, the value of existing bonds will increase so that the effective yield is equal to the yield on bonds of equivalent duration.

Simply put, a long-term Treasury bond fund will increase in value as rates fall. One of the best ETFs for long-term Treasury bonds is Vanguard Extended Duration Treasury ETF (EDV -0.10%).

The fund buys US Treasury STRIPS, which are zero-coupon bonds bought at a discount to face value. Bonds increase in value as they approach maturity. The Vanguard fund’s bond holdings have an average effective maturity of 24.6 years. This long duration makes the fund much more sensitive to changes in interest rates. But if rates fall, the value of his holdings will increase significantly.

As mentioned, the market is already expecting a rate cut in September. This is already rated in bonds. Buying the Vanguard Long-Term Treasury Fund is based on further cuts in interest rates and the expectation that rates will remain low for an extended period of time. It’s very hard to predict, but it’s reasonable to expect the Vanguard fund to perform well over the next few years as the Fed looks to lower rates at a reasonable rate.

The Vanguard fund charges an expense ratio of just 0.06%, relatively low compared to other long-term Treasury bond funds. If you think the interest cuts will stick, this fund could pay off very well in the long run.