Small-Cap Wins in Q3: Top-Performing ETFs in Focus

U.S. small-cap stocks demonstrated a significant rebound in Q3 2025, with the iShares Russell 2000 gaining 11% and outperforming the S&P 500, driven by a 25 bps Fed rate cut in September and robust 3.8% Q2 GDP growth. Despite this, year-to-date performance still lags, and concerns persist over the Russell 2000's elevated P/E ratio of 34.65 and potential short-term volatility from new tariffs announced for October 1, 2025.

Analysis

U.S. small-cap stocks demonstrated a significant rebound in the third quarter, with the Russell 2000 index gaining 11% over the past three months, outpacing the S&P 500's 7.6% increase. This resurgence is supported by strong domestic fundamentals, including an upwardly revised Q2 GDP growth rate of 3.8%, and a dovish monetary policy from the Federal Reserve, which enacted a 25 bps rate cut in September and has signaled the potential for further easing. However, several headwinds warrant caution. Year-to-date, the iShares Russell 2000 ETF (IWM) still lags the SPDR S&P 500 ETF (SPY), with gains of 8.2% versus 12.6% respectively. Furthermore, valuations appear stretched, as the Russell 2000's price-to-earnings ratio has expanded to 34.65, a notable premium over its year-ago level of 25.12 and higher than both the S&P 500 and Nasdaq 100. The reintroduction of trade tensions, with new tariffs announced for October 1, presents a material short-term risk that could trigger volatility, mirroring the segment's weakness earlier in the year.

Key Decisions for Investors

• Investors could consider a tactical rotation into small-caps to capture the strong recent momentum, potentially focusing on outperforming ETFs like FESM and RZV which have seen gains exceeding 14% in Q3.
• Given the elevated P/E ratio of 34.65 and the impending tariffs, a cautious approach is warranted; investors should monitor for signs of the rally weakening and consider sizing positions to account for heightened volatility risk.
• For those with a longer-term horizon, it may be prudent to hold existing allocations rather than aggressively increasing exposure until there is clearer evidence of a sustained trend and valuations become more favorable relative to large-caps.