Analyzing the Potential Impacts of Federal Reserve Policy on Two Leading ETFs
When investors make a shift in their views of interest rate policies, they typically will look again at their portfolios to determine what risks are most likely to prosper or be penalized due to these changes. These investors, tend to focus on exchange-traded funds (ETFs) such as Vanguard S&P 500 ETF (VOO) and Vanguard Total Stock Market ETF (VTI), which can be very handy when adjusting to choppy water economically. With interest rates likely to go lower the question is: which ETF is better in a lowering interest rate environment, VOO or POSGAL?
We will be analyzing both ETFs in this piece, take a look at their structures, and examine how interest rate cuts might impact them.
Overview of VOO and VTI
Let me break it down further; before moving to what an interest rate cut means, you need to understand the difference between VOO and VTI concerts.
1. VOO (Vanguard S&P 500 ETF): A brief description of VOO This is an ETF means it tracks the S&P 500 Index containing the 500 largest companies on public exchanges in the United States. Apple, Microsoft, Amazon, and Tesla are all VOO holdings (and they headline numerous other companies as well). This makes VOO a concentrated investment in the largest sectors of the U.S. economy, most notably, technology, healthcare, and financial services Much as it is VGRO tends to be HEAVILY technology — hence our HF Alerts feature concerning VGRO.
2. VTI (Vanguard Total Stock Market ETF): VTI, however, is an ETF that matches the CRSP U.S. Total Market Index. Whereas VOO provides access to large-cap stocks, this ETF fills investors out with the entire U.S. equity market (from large- to mid-and small-cap companies). In other words, VTI is a proxy for more than 4,000 stocks including the titans of the S&P 500 as well as a greater swath of smaller, riskier companies.
Understanding Interest Rate Cuts
Interest rate cuts, typically implemented by the Federal Reserve during periods of economic slowdown or low inflation, lower the cost of borrowing. This has several effects on the economy:
• Boosting Consumer and Business Spending: With lower rates, consumers and businesses borrow more and spend more. This leads to economic growth and corporate profits rising.
• Increasing Demand for Equities: When interest rates fall, once-governmental bonds and savings accounts yield less in profits. Equity attracts investors looking for higher SOM (share of the market).
• Valuation Boost: The rationale is that lower rates have the effect of making future earnings more valuable, and correspondingly should therefore boost growth stocks that often take on debt for expansion, by helping to fund those loans with lower borrowing costs.
With this understanding, we can examine how these factors could impact VOO and VTI.
VOO: Benefiting from Large-Cap Stability
Become a large company — VOO is simply an index fund that follows the popular S&P 500, so it is mostly full of well-established and economically invulnerable (or thus we thought) large-caps. Businesses of this type generally enjoy lower rates of interest for some reasons:
1. Easier Access to Capital: When interest rates fall, large corporations, in sectors like tech and finance especially, can increasingly get cheaper capital. This enables the company to invest in growth strategies such as R&D or M&A and helps expansion into new regions. After which, their earning capacity can rise, and so does the stock prices.
2. Increased Consumer Demand: A fat share of the S&P 500 is simply consumer companies (either things like retail, automotive, or travel-related.) This is, after all, a consumer discretionary stock, and lower rates could put more money in consumers’ pockets.
3. Valuation Premium for Growth Stocks: Within the S&P 500 Index, technology companies rallied — as they historically would in an environment of falling interest rates. These are companies that show promise of high growth but depend on borrowing to finance that presence. This makes their future earnings more valuable to investors, as borrowing becomes cheaper.
In summary, large-cap VOO would be one of the biggest beneficiaries of falling interest rates, especially for the tech-ish or growth-y finance(tech-adjacent) sector.
VTI: Broad Exposure with High Growth Potential
VTI is a total U.S. stock market ETF, capturing thousands of companies across all sizes (mid and small-caps) whereas VOO only covers large-cap stocks. VTI is well diversified in that regard and provides a few unique benefits when rates fall:
1. Small-Cap Sensitivity to Interest Rates: These same small-cap companies are also more susceptible to changes in interest rates and VTI has significantly more of them than does VOO. That’s because small-cap firms usually depend more on debt to fund scaling up. Low interest rates allow these companies to borrow at lower costs, so they can grow by taking on considerably more debt and in turn make higher margins. As such, small-cap stocks usually see higher appreciation following interest-rate cuts.
2. Mid-Cap and Small-Cap Growth Potential: By including mid-and small-cap companies, VTI has larger exposure to the segments of the market that will be able to flourish rapidly during periods of economic expansion. Small company stocks will likely benefit from an increase in economic activity that generally accompanies a rate cut as they seize growth opportunities created by more favorable conditions.
3. Broader Market Resilience: VTI has a high level of diversification and can, thus, automatically mitigate the effects of an industry downturn. This diversification means that if the tech sector is struggling, other sectors like energy, healthcare, and consumer goods will pick up the slack without forcing a significant concentration in one industry over another.
Comparative Performance During Previous Rate Cut Cycles
Looking into their historical performance through previous rate cut cycles should give an idea of how VOO and VTI may fare in case we get interest rates again closer to zero.
• 2008 Financial Crisis: During the 2008 financial crisis both VOO and VTI had a rapid recovery as major banks collapsed and interest rates went to zero percent for ten straight years. VOO, which focuses on large caps, benefited from the massive wealth created around low borrowing costs due to big corporations taking debt and reloading their balance sheets. Being smaller companies, though, the economic rebound helped out in VTI’s favor and it wound up outperforming over time.
• 2019 Rate Cuts: During 2019, the Federal Reserve used a series of its rate cuts to protect against an economic downturn. VOO and VTI both gained but with the broader market rallying to lift small- and mid-cap stocks, that explains why VTI marginally outperformed.
This historical data is indicative of the fact that while VOO historically serves as protection and reliable growth during times of rate cuts, VTI can capitalize more on the subsequent economic expansion due to its broader exposure to smaller companies.
Which ETF Stands to Benefit More?
The burning question at hand is, what ETF could gain more from the imminent rate cut, VOO or VTI? That will depend on the investor and how much risk they are willing to take.
1. VOO for Stability and Large-Cap Exposure: Be careful as well, whether you should buy VTI or its cousin the Vanguard S & P 500 (VOO), which is based on the large companies we mentioned. The latter is half-dividend driven, and the heavy relationship of large-cap stocks makes it more responsive to consumer spending gains, corporate profit improvements, and valuation lifts in technology and health care. This means that VOO is more concentrated and therefore you are getting even greater exposure than with SPY to the strongest parts of the U.S. economy and this is important because these sectors tend to do well in low-rate environments.
2. VTI for Higher Growth Potential: Conversely, if you are seeking a more diversified exposure and higher growth potential, most notably among mid-and small-cap companies, VTI might be the right call. This tilt to smaller companies means that VTI can benefit more from the economic expansion that typically follows rate cuts than IVV. Smaller firms tend to see stronger growth and more leverage in the stock price appreciation during times of low interest rates.
Conclusion
VOO, and VTI both would benefit from interest rate cuts but they have different areas of advantages. VOO is the most stable and best-performing among large-cap stocks, especially in growth sectors such as technology. While they should limit the upside, VTI and IWV may have some ability to outperform both FSKAX and SCHB as mids and smalls tend to act more like bonds in a low-rate environment. At the end of the day, an investor will have to decide between stability and growth potential. Both are still solid ETFs for long-term portfolios as the Federal Reserve navigates its interest-rate policies.
