Interest rates are one of the most important factors affecting the economy and investment outlook. And after the sharpest rate hiking cycle in 40 years, it appears the Federal Open Market Committee could be entering a cycle of lower interest rates beginning with their upcoming meetings on September 17-18.  

Let’s examine three ETF categories that might be lifted by falling interest rates.

Small Company Stocks
Although rate cuts have historically been bullish for the broader stock market, small companies could become the biggest beneficiaries.

Since smaller companies tend to carry higher loads of debt compared to larger peers, falling rates can be a huge boost. With lower financing costs, small businesses have better cash flow. Besides spending less on interest costs, it allows them to affordably invest in new projects, technology, and infrastructure that might have been prohibitively expensive with higher interest rates.

Going back to 1970, small caps outperformed large cap stocks 76% of the time in the subsequent 12 months after interest rates fell.

The Schwab US Small-Cap ETF (SCHA) is among the cheapest small cap ETFs. With almost $18 billion in assets, the fund charges just 0.04% annually. SCHA is linked to the Dow Jones U.S. Small Cap Total Stock Market Index.

Utilities
After a slow start, utilities are now 2024’s top performing S&P 500 industry group. And the prospect of lower interest rates has the sector jumping for joy.

Because utilities have significant capital requirements to build and maintain infrastructure, elevated borrowing costs can be a drain.

On the other hand, low rates minimize the cost of servicing debt, which can improve profit margins. Additionally, utilities often pay significant dividends, and as interest rates fall, these stocks become more attractive to income-seeking investors.

Finally, for advisors and investors who believe the U.S. economy is heading into recession, the stability of utilities could help to navigate higher volatility and unwelcome surprises.

The Utilities Select Sector SPDR Fund (XLU), which tracks utilities within the S&P 500, is an easy way to get affordable access. With $17.6 billion in assets, the fund charges 0.09% annually.

Long-Term Bonds
Declining interest rates typically result in higher bond prices due to the inverse relationship between bond prices and interest rates. Because long-term bonds are most sensitive to rate changes, it’s the one area of the bond market that could get the biggest lift.

The Vanguard Long-Term Bond ETF (BLV), which is linked to the Bloomberg U.S. Long Government/Credit Float Adjusted Index, was introduced in 2007 and has a modest expense ratio of just 0.04%.

Around half of BLV's portfolio is committed to U.S. long-term bonds while the rest is allocated to investment grade debt from corporations. For bond maturity, 37.80% of the portfolio is allocated to debt with a duration of 25 years or longer while 51.70% is committed to debt with maturities between 15-25 years.

When rates decline, prices of long-term bonds typically increase more significantly than those of short-term bonds. Investors holding long-term bonds, such as those with maturities exceeding ten years, can see substantial capital appreciation in a falling rate environment.

Ron DeLegge II is the founder of ETFguide.com and author of several books, including "Habits of the Investing Greats" and "Portfolio Architecture: A Handbook for Investors."