As the Federal Reserve pivots toward monetary easing, small-cap equities are stepping into the spotlight. With back-to-back rate cuts in September and October 2025, and markets pricing in additional cuts through 2026, financial advisors are reevaluating their small-cap exposures.
Among the leading small-cap indices —Russell 2000, S&P SmallCap 600, and CRSP Small Cap Index —the Russell 2000 stands out as particularly well positioned to capitalize on this environment.
Why Small Caps Respond to Rate Cuts
Small-cap companies are typically more sensitive to interest rate changes because they rely on domestic financing and have shorter debt maturities. Lower rates reduce borrowing costs, improve operating margins, and stimulate consumer demand. These dynamics tend to benefit smaller firms more than their large-cap counterparts.
Following the October rate cut, the Fed’s benchmark now stands at 3.75% to 4.00%, with another cut expected in December. According to the CME FedWatch Tool, the futures market assigns the highest probability (28.4%) to rates falling to 3.00%-3.25% by the end of 2026. There is also a meaningful chance of rates dropping even further, with 24.4% probability for a 2.75% to 3.00% range and 19.9% for a slightly higher 3.25% to 3.50% range.
With expectations for 50 to 100 basis points of additional easing, it is important to evaluate how each small-cap index is constructed and how that affects performance in a rate-cutting cycle.
Comparing the Indices
The Russell 2000 Index offers the broadest representation of the small-cap universe, comprising approximately 2,000 stocks and providing deep sector exposure. Its composition leans more toward cyclical sectors—financials, industrials, and consumer discretionary —which tend to outperform during economic recoveries. Unlike other indices, the Russell 2000 does not screen for profitability, allowing for the inclusion of unprofitable companies, which are often the most responsive to interest rate cuts and early-cycle growth.
In contrast, the S&P SmallCap 600 Index applies a profitability screen, including only companies with positive earnings. While this quality bias can offer downside protection, it may limit upside potential during aggressive risk-on periods or early-cycle recoveries. The index’s smaller universe of roughly 600 stocks results in more concentrated exposure, which can be both a strength and a limitation depending on market conditions.
The CRSP Small Cap Index uses a market-cap-based, rules-driven approach to define small caps. However, its methodology can lead to overlap with mid-cap stocks, diluting pure small-cap exposure. Additionally, the CRSP index is less widely adopted among financial advisors and institutions, resulting in lower visibility and fewer investment products tied to it.
Why Russell 2000 Stands Out
The Russell 2000’s broader and more cyclical composition makes it particularly responsive to monetary easing. Unprofitable and growth-oriented companies, which tend to be penalized in high-rate environments, stand to benefit the most as borrowing costs decline and investor risk appetite increases. The index also has greater exposure to domestically focused businesses, which aligns well with the Fed’s objective of stimulating internal demand. As credit conditions ease, these firms are likely to experience improved access to capital and stronger revenue growth.
Implications for Portfolio Strategy
For financial advisors positioning portfolios to benefit from a rate-cutting cycle, the Russell 2000 offers compelling upside potential. Its higher beta profile and inclusion of speculative growth names provide opportunities for alpha as risk-on sentiment returns.
While the S&P SmallCap 600 may appeal to advisors seeking quality exposure, its profitability screen and narrower scope may underperform in stimulus-driven environments. The CRSP Small Cap Index, despite its rules-based approach, lacks the purity and visibility needed to capture the small-cap recovery fully.
Given the current macro environment, characterized by consecutive rate cuts and expectations for continued easing, the Russell 2000 stands out as the most effective index for capturing the benefits of a monetary policy shift.
Author: Jared M. Orr, CFP®, CIMA® is a Portfolio Strategist at an Asset Manager.
Editor: Greg Filbeck, CFA, FRM, CAIA, CIPM, PRM, Samuel P. Black III, Professor of Finance & Risk Management, Penn State Erie, mgf11@psu.edu.