These 2 ETFs Could Outperform as Jerome Powell Lowers Rates

Key Points

• The Federal Open Market Committee also updated its dot plot, indicating that most FOMC members think another three interest rates are coming in the near term.

• Interest rates have significant influence in the stock market.

• Real estate and small-cap stocks could get a boost.

• 10 stocks we like better than Vanguard Small-Cap Value ETF ›

The last interest rate cut was in December 2024. Nine months later, Federal Reserve Chair Jerome Powell and the Federal Open Market Committee (FOMC) decided it was again time to lower the Fed's benchmark federal funds rate -- this time by a quarter of a point down to a range of 4% to 4.25%. In a press conference following the Fed's September meeting, Powell called the decision a "risk management cut" that was needed if the economy were to suddenly take a turn for the worse.

The FOMC dot plot, a chart that shows where each member of the FOMC expects rates to trend in the future, showed that the majority of members expect two more rate cuts in 2025 and only one more in 2026, with the federal funds rate ending 2026 around 3.4%. Even though this is higher than what the market expected, it still means more rate cuts are coming.

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Here are two exchange-traded funds (ETFs) that could outperform in the falling-rate environment.

Image source: Getty Images.

Real Estate Select Sector SPDR Fund

The Real Estate Select Sector SPDR Fund (NYSEMKT: XLRE) contains a basket of stocks in the real estate management and development and real estate investment trust (REIT) sectors. REITs operate under a special type of corporate structure that allows them to avoid paying corporate taxes as long as they meet certain conditions, including paying out at least 90% of taxable income to shareholders. Essentially, REITs enable investors to get exposure to real estate without owning physical assets themselves.

Lower interest rates should trickle down to lower mortgage rates, which should stimulate more investment in the space because it's cheaper to borrow. But lower interest rates are also helpful because they typically lower cap rates, which is a key way investors evaluate the riskiness of a real estate investment. Investors can calculate the cap rate on a commercial real estate investment by dividing net operating income by the value of a property. A higher cap rate suggests higher returns and quicker return on investment, but also implies more risk, so lower cap rates are indicative of more demand and a more fluid market.

XLRE's top holdings are Prologis, a logistics company that helps major retailers and e-commerce players operate warehouses; and several REITs like Welltower, which specializes in healthcare infrastructure; Equinix, which invests heavily in data centers; and Simon Property Group, a REIT that largely owns malls. Because XLRE owns many REITs, which pay strong dividends, the ETF has a yield of 3.28%. Now, I still think the real estate sector could face challenges, due to complexities in the market, but owning some real estate exposure with strong passive income in a falling-rate environment is typically a good idea.

Vanguard Small Cap ETF

As the name suggests, the Vanguard Small Cap Value ETF (NYSEMKT: VBR) provides exposure to small-cap value stocks by tracking the US Small Cap Value Index. It's important for investors to understand that while a small-cap stock is typically considered one with a market cap between $250 million and $2 billion, there are actually much larger stocks in VBR. The fund specifically invests in the bottom 15% of the U.S. equity market and avoids all large-cap stocks.

Smaller stocks tend to benefit from rate cuts for a number of reasons. First, their balance sheets typically aren't as strong as large-cap stocks and carry more floating-rate debt, which gets cheaper to pay off as rates come down. Second, investors get more interested in riskier assets when rates come down because safer assets don't yield as much. Smaller-cap stocks have underperformed in recent years. For instance, VBR is up 86% over the past five years, which is still quite strong, but the broader benchmark S&P 500 is up over 100%.

I also like how VBR owns some of the more unloved sectors that could benefit from rate cuts. For instance, the ETF is heavily invested in financials (21% of fund), which could see more lending and a better credit environment if rates come down, as well as consumer discretionary stocks (14.6% of fund), which can hold up better during an economic downturn. Some of VBR's top holdings include NRG Energy, Williams-Sonoma, and First Citizens BancShares, one of the top-performing regional bank stocks.

Small companies can be at risk if the economy tips into a recession because they don't have as strong balance sheets, but many of the top companies in VBR are bigger than a more traditional small-cap and therefore have better balance sheets with more protection.

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Bram Berkowitz has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Equinix, Prologis, Simon Property Group, and Williams-Sonoma. The Motley Fool recommends the following options: long January 2026 $90 calls on Prologis. The Motley Fool has a disclosure policy.