Small-cap stocks had their best first half in 35 years in 2026, and a big reason is that interest rate policy has cooperated. We'll get into the details in a bit, but the series of rate cuts we saw in 2025 gave small caps a valuable tailwind, and the general assumption throughout the first half was that the Fed's next move would be another rate cut.
Fast-forward to the present, and that's no longer the case. In fact, the market is pricing in a 57% chance of a rate hike when the Fed meets in a couple of weeks, according to the CME FedWatch tool. And the base case is now for the federal funds rate to be at least 50 basis points higher in a year than it is now.
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Of course, there's a lot that can happen over the next year, and projections can be (and have been) wrong. But one ETF in my portfolio I'm watching very closely now is the Vanguard Small-Cap Value ETF (VBR -0.67%).
What is the Vanguard Small-Cap Value ETF?
As the name suggests, the Vanguard Small-Cap Value ETF is an index fund that invests in smaller stocks that have value characteristics. Without getting too deep into the weeds here, most stocks are classified into one of two categories: value or growth. Value stocks tend to be more mature, stable businesses with reliable cash flow (though this isn't always the case).
NYSEMKT: VBR
Key Data Points
The fund owns 838 small-cap stocks altogether as of the latest information, with a median market cap of $10.6 billion. As you might expect from a value stock fund, you'll find a lot of companies from the industrial, financial, and consumer discretionary sectors, with less exposure to things like technology and healthcare.
The average stock owned by the Vanguard Small-Cap Value ETF trades for 2.0 times book value and has a price-to-earnings (P/E) ratio of 17. For context, the average S&P 500 stock trades for 5.2 times book and about 25 times earnings.
Why rising rates could be a problem
Here's why the Vanguard Small-Cap Value ETF has been such a beneficiary of rate cuts, and why it could quickly reverse course if we get a rate hike.
In a nutshell, smaller companies borrow differently from large ones. They rely more on bank credit lines and term loans and less on long-dated fixed-rate bonds that larger companies often issue.
The big takeaway is that credit lines and term loans often have floating interest rates. When the Fed raises rates, the cost of carrying debt immediately gets higher. Roughly 40% of companies in the Russell 2000 small-cap index carry floating-rate debt, and as a general rule, value stocks tend to be more debt-reliant than growth stocks.
Of course, there are many moving parts in an index fund with more than 800 stocks, and not all would suffer equally if interest rates rose. For example, bank stocks and insurance companies often earn more when rates rise. But overall, rising rates are likely to be a more negative factor for the Vanguard Small-Cap Value ETF than for an S&P 500 index fund, or even a broader small-cap ETF like a Russell 2000 index fund.
Small-cap value as a long-term investment
To be clear, I've accumulated a position in the Vanguard Small-Cap Value ETF over the past couple of years because I intend to hold it for decades. Small-cap stocks as a whole have traded at a steep valuation discount relative to large-caps for a long time, and growth has outperformed value in recent years.
Over the long-term, small-caps have historically delivered strong returns, and that's why I'm investing. Not because of what I think interest rates or any individual sector will do over the next few months, or even over the next few years. But it's important to be prepared for volatility if the Fed raises rates, and to understand what's causing it.
