Why Rate Cuts Could Benefit an Already Booming ETF Industry

The Federal Reserve’s recent interest-rate cut may give an extra boost to the already booming ETF industry.

Investors had been anticipating the Fed’s decision for some time, but analysts said certain sectors and strategies stand to gain from lower rates. One area to watch is the $7.4 trillion money market fund industry, which could become less attractive to investors if interest rates continue to drop through the rest of this year. A more risk-on environment is expected to drive assets out of money markets funds and into ETFs. “I think the logical landing spot, given their increasing usage and depth of strategies, is going to be the ETF market,” said Matthew Bartolini, managing director at State Street Global Advisors.

Money, Money, Money

The last time interest rates were at this level, back in late 2022, the money market industry was about $5 trillion. “It’s not going to be one for one, and it’s not going to be immediate,” Bartolini said. “I just think over the next year or so, as the Fed continues to ease policy… that’s a sizable pile of capital that could flow into ETF markets.” 

Some of those outflows into ETFs could end up in the financial services sector, which tends to outperform the broader market when the Fed cuts rates. Early flows already reflect that trend, with nearly $750 million entering financial sector ETFs the day of the Fed decision, Bartolini said. The size of the money market industry has ballooned of late. According to Bloomberg:

• Since March of 2022, when the Fed began raising interest rates, money market assets have grown by more than $2.5 trillion.
• Money markets gained more than $320 billion this year alone.

The Fix Is In. Another possible winner in a post-rate cut world is fixed-income products, particularly as the yield curve steepens, said Paul Cahill, ETF national sales director at AllianzIM. The question is whether attention will go more toward short-term or long-term bonds. Rate cuts make fixed income products more attractive, but it’s easy to overestimate their benefits, even with “coupon income” back in vogue. “Traditional fixed income… is poorly priced to provide what it always has, that ballast against portfolio volatility,” Cahill said.

Taking market swings of the past five years into consideration is also crucial to preventing overreaction, said Morningstar analyst Dan Sotiroff. For investors, he advises staying the course amid a potential shift toward long-term bonds. “You would expect money to come out of the shorter end, to go more towards intermediate and longer-term stuff,” Sotiroff said. “But I’ve been surprised in the past, so I wouldn’t be surprised to see something different.”