GS strategist says quality small-cap stocks worth a look as the Fed embarks on rate cuts

Goldman Sachs’s head of public investing suggested investors consider certain small-caps stocks with the Federal Reserve set to pull back interest rates, a move widely anticipated to start next week.

Investors have been diversifying from large-caps stocks (SP500) including the Magnificent 7 group of mega-cap tech names, and small-caps hold a “meaningful opportunity,” with rate cuts ahead, Ashish Shah, chief investment officer of public investing at Goldman Sachs Asset Management, said in a CNBC interview Thursday.

"They're going to be the primary beneficiaries in the corporate space of rate cuts," Shah said of small-cap companies, which have a higher share of floating-rate interest loans than large-cap businesses. "But you got to focus on the quality,” he said.

It's "tough" buying the Russell 2000 (RTY) index of small-caps because it includes "poor-quality" constituents like meme stocks, Shah said. Acknowledging his bias, he said he prefers the Goldman Sachs Small Cap Core Equity ETF (NYSEARCA:GSC).

"That's where we really focus on quality companies that are both growers as well as represent value," he said. "But I do think you can take any really high-quality, small-cap active strategy, and that's going to perform over the course of the next six to 12 months."

So far this year, the Goldman Sachs Small Cap Core Equity ETF (GSC) has risen 11.5%, outstripping the Russell 2000's (RTY) +4.2% gain. The S&P 500 (SP500) has risen +17%. Shah noted the "best month for small caps is coming up,” with January around the corner.

As for the Magnificent 7 and other large-caps (SP500)?

"I would do exactly what everyone in the market has been doing. You see one of the biggest outflows of large-caps over the course of the last month or two," Shah said.

"That is because people have really gotten overweight those large-caps, whether it's global investors, whether it's U.S. investors. If you've had passive allocation, you've gotten overweight this space, and it's time to diversify your equity portfolio."

Odds of the Federal Open Market Committee cutting its key interest rate by 0.25% from 5.25%-5.5% were above 60% as of late Thursday, suggesting debate is still brewing over whether a cut of 0.50% is possible.

“I'm really concerned that people are hanging back," because of uncertainty around the U.S. elections in November, Shah said. "They're going to miss the opportunity to lock in yield, to lock in returns in the equity market if they don't pay attention.”

Here are some ETFs that track small-caps: (IWM), (IJR), (VB), (XSHQ), and (DFAS).

More on the markets