The Fed's Divided Rate Cut and Its Implications for Small-Cap, Mid-Cap, and Bank ETFs

The Federal Reserve's divided approach to rate cuts in 2025 has created a mixed-rate environment, fueling divergent performance across equity and financial sectors. While large-cap stocks have historically dominated during prolonged bull markets, the current cycle-now in its 14th year-shows signs of reversal, with small-cap and mid-cap ETFs gaining traction. Meanwhile, bank ETFs are navigating a complex landscape of regulatory shifts and valuation dislocations. For investors, this environment presents opportunities to identify undervalued ETFs poised to outperform.

Small-Cap ETFs: A Cycle of Rebalancing

Small-cap stocks have historically outperformed large-caps every 11 years on average, and 2025 marks the 14th year of the current large-cap dominance cycle. This suggests a potential inflection point. According to a report by Hartford Funds, small-cap and mid-cap stocks are trading at record-low valuations relative to the S&P 500, with earnings growth expected to outpace large-cap peers after years of underperformance.

Performance metrics reinforce this trend. The Avantis U.S. Small Cap Value ETF (AVUV) has returned 4.5% year-to-date in 2025, while the Invesco S&P SmallCap 600 Pure Value ETF (RZV) has surged 7.7%. The T. Rowe Price Small-Mid Cap ETF (TMSL) has posted an even stronger 12.7% return, outpacing broader market averages. These gains are supported by a macroeconomic backdrop of strong GDP growth and easing inflation, which favor small-cap stocks with higher U.S. market exposure.

Mid-Cap ETFs: The "Sweet Spot" of Growth and Stability

Mid-cap ETFs are emerging as a balanced alternative to both small-cap and large-cap strategies. According to Nasdaq, mid-cap ETFs like the First Trust Mid Cap Core AlphaDEX Fund (FNX) and the SPDR S&P Midcap 400 ETF Trust (MDY) have surged in late 2025, with FNX up 5.2% and MDY up 4.8% in a single month. Mid-cap companies derive 77% of their revenue domestically, compared to 59% for large-cap firms, insulating them from global trade risks while retaining growth potential.

The Federal Reserve's revised 2026 GDP forecast of 2.3% and improved unemployment projections further bolster mid-cap prospects. These ETFs are particularly well-positioned to benefit from AI-driven productivity gains and a short-term easing cycle, provided they maintain strong earnings coverage.

Bank ETFs: Navigating Valuation Dislocations and Regulatory Shifts

Bank ETFs have shown mixed performance in 2025, with large banks outpacing regional counterparts. The Invesco KBW Bank ETF (KBWB) gained 17.8% year-to-date, driven by strong returns from JPMorgan Chase and Goldman Sachs. European banks, represented by the Themes Global Systemically Important Banks ETF (GSIB), surged 40.4% amid improved loan demand and non-fee income. However, valuations for these ETFs remain elevated, with GSIB trading at a 1.2x price-to-book multiple-well above its five-year average of 0.79x.

For undervalued opportunities, the State Street SPDR S&P Bank ETF (KBE) stands out. With a P/E ratio of 11.29x-significantly below the S&P 500's 27.29x-and a Zacks Rank #1 (Strong Buy), KBE has gained 5.2% in one month. Regional banks, though lagging large-cap peers, benefit from regulatory clarity, including less stringent stress tests and revised compliance timelines, which could enhance long-term capital planning.

Risks and Opportunities in a Mixed-Rate Environment

While the Fed's rate cuts and improved economic forecasts create tailwinds for small- and mid-cap ETFs, structural challenges persist. Small-cap firms, for instance, often rely on short-term debt and face weaker earnings coverage in high-rate environments. Similarly, J.P. Morgan Research warns of potential U.S. economic downturns in the second half of 2025.

Active ETFs, however, are gaining traction as a solution. Assets under management in U.S. active ETFs surpassed $1 trillion in 2025, driven by their ability to capitalize on valuation dislocations and macroeconomic shifts. Deloitte predicts this trend will accelerate, with active ETF AUM projected to reach $11 trillion by 2035.

Conclusion: Positioning for 2026

The Fed's divided rate cut has created a fragmented landscape where small-cap, mid-cap, and select bank ETFs offer compelling value. Investors should prioritize ETFs with strong earnings momentum, low valuations, and exposure to domestic growth drivers. For small-cap, AVUV and TMSL represent robust options. Mid-cap ETFs like FNX and MDYV balance growth and stability. In the banking sector, KBE and regional bank ETFs with improved regulatory clarity could deliver outsized returns. As 2026 approaches, a diversified approach that leverages these opportunities while hedging against macroeconomic risks will be critical.