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The US Federal Reserve’s decision to cut interest rates in September by an aggressive 50 basis points (bps) to between 4.75% and 5% raises the question of how factor ETFs can perform in this environment.

The move by the Fed marks a turning point against the rate hiking cycle that was brought in to tackle soaring inflation. Now, it is anticipated that US interest rates are set to fall further, with Fitch Ratings for example forecasting that the upper interest rate will be cut to 4.5% by the end of this year.

By the end of 2025 the same rate is set to drop to 3.5% the rating agency estimated.

Which factor ETFs will outperform

Factor ETF providers will need to create a strategic approach to understanding the current environment that they are operating in, where recent factor patterns must be analysed to evaluate where the market would be beneficial to their portfolios.

Bob Hum, US head of factor and outcome ETFs at BlackRock, said that to understand how factors might perform in today’s rate cutting cycle, it is essential to evaluate the backdrop through the lens of long-term data such as prior rate cutting cycles, while staying flexible and dynamic to respond to the unique characteristics of the current environment.

“The economic regime that markets are operating in, elements like the strength of the US economy, the level of unemployment and changes in inflation, is a critical variable that can meaningfully impact factor cyclicality.”

“In a ‘goldilocks’ economy with resilient growth and declining inflation, cyclically-oriented factors like value and momentum may be preferred while more defensive factors like low volatility could lag.”

“Alternatively, quality and low volatility factors may be better suited to navigate a downturn and potential recession.” he said.

As the economic backdrop shifts and trends change, an actively managed factor timing strategy such as the iShares US Equity Factor Rotation ETF (DYNF) can provide dynamism to investor portfolios.

BlackRock’s Systematic Group manages this strategy with a data-driven and quantitative approach, modelling numerous economic variables across decades of history and hundreds of US large and mid-cap stocks.

As of 30 September the ETF is overweighting factor characteristics such as momentum and quality, while underweighting low size and low volatility.

Reviewing which factors might benefit from a rate-lashing cycle, Dr Marcin Wojtowicz, ETF research analyst at UBS Asset Management, reflected that rate cuts are generally supportive of broadly defined growth stocks due to a reduction in the discount rate.

“Growth stocks generally provide expected profits further into the future, so a reduction in the discount rate has a larger positive impact.

“Conversely, factors such as value or dividend may experience relative underperformance in a falling interest rate environment.” he said.

Nick Kalivas, head of factor and core equity ETF strategy at Invesco, said if an investor envisages the Fed continuing to cut rates, he expects such a scenario to benefit the yield factor as dividend yields become more competitive to money market and short-term rates.

“Historically, we have seen the year over year growth rate of money market fund assets coincide with the 3-month T-bill yield,” Kalivas said.

“We have also seen relative performance of yield factor coincided with declining rates.”

Past performance as interest rates fall

Research conducted by Alex Lustig, a senior consultant for data driven investment management solutions firm Confluence, examined stock returns between 1982 and 2023 in the event of sudden interest rate cuts.

It was found that growth equity outperformed value equity during an interest cutting trend, but this also depends on the pace of the rate decline.

A reduction beyond 5% is necessary to influence growth stocks in the US market, they outperform value equity by 226bps for every 10% decrease after a 5% interest rate.

Also, the study revealed that if the 10-year rate decreases by 15%, growth equity outstrips value equity by around 2.2%.

Rates cuts in different environments

Of course, rate cutting cycles can be prompted by many diverse circumstances as we have seen in recent times such as the financial crash Dr Wojtowicz and Kalivas agreed that each time there are several variations behind any decision to begin slashing interest rates.

“For example, the rate cuts following the financial crisis were done in a recessionary environment.” Dr Wojtowicz said.

“A cycle of rate reductions during Covid was accompanied by large fiscal spending, effects on the real economy and it resulted in a technology sector rally, also precipitated by uncovering of changes that technology can bring such as remote work.”

“The current interest rate cycle comes after an inflationary period. It is a different set of conditions compared to the mentioned previous rate reduction cycles, so it may be inappropriate to draw inference for the present cycle.”

As the current cycle is generally expected by the market, investors need to account for the extent to which it is already reflected in market prices. Kalivas said that one must be careful about making blanket statements when it comes to rates.

“Monetary ease due to significant economic weakness, think financial crisis, has different implications than rate cuts linked to adjusting the real rate lower because of falling inflation in a period of sustained economic growth.”

He added: “Soft landing has the potential to benefit smaller stocks and value stocks, while rate cuts linked to stress would benefit low volatility and more quality stocks.”

Given the high level of concentration and contribution to risk present in the cap weighted S&P 500, investors should investigate factor-based strategies to meet their goals and objectives.

What will be the election impact?

The down-to-the-wire US presidential election outcome is sure to have an impact on the factor ETF market in the current rate reducing climate, although to some it is debatable just how far that political headwinds can usurp the markets in driving top line growth.

Hum explained that it is not unusual for markets to experience heightened volatility during an election year. “Over the past 100 years, markets have typically exhibited higher risk and lower returns during election months, say between September and November, compared to non-election months.”

“Investors seeking potential resilience during this period can consider defensive strategies like quality and minimum volatility.”

He said. A victory for Kamala Harris or Donald Trump is highly likely to have an influence on certain assets due to policy direction, such as ESG assets as they should receive a boost reversing their recent fortunes if Harris wins, while fossil fuels would benefit more if Trump wins a second term at the White House.

During Harris’ time as vice-president the Inflation Reduction Act was signed two years ago and is viewed as the flagship legislation in the commitment to an economy that is powered by clean energy.

However, the Biden presidency has also seen a surge in gas and oil production, with crude oil production reaching 13.2 million barrels per day in June this year according to the US Energy Information Administration.

This was 6.5% more than last year’s record high of 12.5 million daily crude oil barrels. Trump is also well known to be very supportive of the cryptocurrency market and has created a new crypto venture – World Liberty Financial – which trades cryptocurrencies.

European stocks could also be effected by the prospect of Trump sponsored tariffs, where the former president has threatened to have import penalties from Europe on certain products of up to 20%.

Peter Taberner is a freelance journalist