As the Fed Pivots, These 3 ETFs Are Positioned to Outperform

Key Points

• Recent economic data shows cooling inflation and weakening jobs, making September rate cuts increasingly likely.

• Small-cap stocks, biotech companies, and real estate investment trusts historically outperform when the Fed eases monetary policy.

• These three ETFs provide targeted exposure to rate-sensitive sectors and industries.

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The Federal Reserve's inflation battle appears to be ending, and investors who position themselves correctly could capture significant gains. Producer prices unexpectedly dropped in August, while the U.S. government revised past employment figures downward by a staggering 911,000 jobs. That's the kind of one-two punch that forces central bankers to pivot from fighting inflation to supporting growth.

Wall Street has gotten the message. Bank of America (NYSE: BAC) projects two 25-basis-point cuts this year, while Goldman Sachs (NYSE: GS) sees three cuts in 2025 and two more in 2026, potentially bringing rates down to 3.00% to 3.25%. For investors, this shift creates a clear playbook: Certain sectors and strategies thrive when rates fall, and exchange-traded funds (ETFs) offer the cleanest way to capture these trends.

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Small-caps ready to close the gap

The iShares Russell 2000 ETF (NYSEMKT: IWM) stands out as the most direct beneficiary of lower rates. Small-cap companies carry heavier debt loads than their large-cap counterparts and generate most revenue domestically, making them acutely sensitive to borrowing costs. The Russell 2000 has lagged the S&P 500 by historic margins during the Fed's hiking cycle, creating a coiled spring effect.

With an expense ratio of just 0.19% and exposure to 2,000 small-cap stocks, the fund offers broad diversification across the segment. It's trading at a price-to-earnings (P/E) ratio of 17.4, versus over 20 for the S&P 500. Small-caps haven't looked this cheap relative to large-caps in years. In past easing cycles, small-caps have often outperformed the broader market by double-digit spreads -- the kind of torque that can transform portfolios.

Biotech's high-beta opportunity

The SPDR S&P Biotech ETF (NYSEMKT: XBI) takes a different approach to rate sensitivity. Its equal-weight structure means heavy exposure to cash-burning small- and mid-cap biotechs that depend on capital markets for survival. When rates fall, funding concerns ease, and merger activity typically explodes as big pharma goes shopping with cheaper financing.

The biotech industry has been absolutely crushed during the rate-hiking cycle, with many stocks down 70% to 80% from their peaks. The fund's 0.35% expense ratio is reasonable for specialized exposure, and while many holdings are unprofitable (making traditional P/E ratios meaningless), that's precisely the point. These speculative companies offer the highest beta to liquidity conditions -- when the Fed opens the spigots, few sectors respond more dramatically.

Real estate's income resurrection

The Vanguard Real Estate ETF (NYSEMKT: VNQ) provides the income and stability component of a rate-cut portfolio. Real estate investment trusts (REITs) suffer doubly when rates rise -- their financing costs increase while their dividend yields become less attractive versus bonds. That dynamic reverses powerfully when rates fall.

The fund yields 3.76%, well above the S&P 500's 1.3%, and carries rock-bottom expenses at 0.13%. REITs must distribute 90% of taxable income as dividends, creating a reliable income stream that becomes increasingly valuable as bond yields decline. While REIT valuations are often discussed in terms of funds from operations (FFO) rather than P/E ratios, the story remains the same -- cheaper debt directly expands distributable cash flow, driving both yields and share prices higher.

Portfolio construction for the pivot

These three ETFs create a balanced approach to playing rate cuts. The iShares Russell 2000 ETF provides broad small-cap exposure for capturing domestic growth acceleration. The SPDR S&P Biotech ETF adds speculative upside for investors willing to embrace volatility in exchange for potential home runs. The Vanguard Real Estate ETF balances the portfolio with defensive income and lower correlation to growth stocks.

The Fed's pivot from hawk to dove appears imminent. Economic data will continue driving the narrative, but the direction seems clear -- rates are heading lower. For investors who missed the narrow tech rally that dominated the hiking cycle, rate-sensitive sectors offer a second chance at outperformance. These three ETFs provide the tools to capitalize on the Fed's next chapter.

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Bank of America is an advertising partner of Motley Fool Money. George Budwell has positions in Vanguard Real Estate ETF. The Motley Fool has positions in and recommends Goldman Sachs Group and Vanguard Real Estate ETF. The Motley Fool recommends SPDR Series Trust-SPDR S&P Biotech ETF. The Motley Fool has a disclosure policy.