The Russell 2000 is a barometer for small-cap stocks. It is a subset of the broader Russell 3000, which represents the entire U.S. stock market. Specifically, the Russell 2000 measures the performance of the 2,000 smallest stocks in the Russell 3000, which collectively account for 7% of U.S. equities by market capitalization.
Tom Lee, managing partner and head of research at Fundstrat Global Advisors, sees substantial upside in the small-cap index due to cheap valuations and interest rate cuts. Earlier this year, he told CNBC the Russell 2000 could finish the year above 3,000, which implies 49% upside from its current level of 2,014.
Investors can capitalize on that opportunity by purchasing shares of the Vanguard Russell 2000 ETF (VTWO 1.03%). Here are the important details.
The Vanguard Russell 2000 ETF
The Vanguard Russell 2000 ETF tracks the Russell 2000, an index that includes about 2,000 small-cap companies that represent a blend of value stocks and growth stocks from all 11 market sectors. The index fund is most heavily weighted toward stocks in four sectors: industrials (19.2%), financials, (14.8%), healthcare, (14.8%), and technology (13.7%).
The 10 largest holdings in the Vanguard Russell 2000 ETF are listed by weight below.
- Super Micro Computer: 1.5%
- MicroStrategy: 0.9%
- Comfort Systems USA: 0.4%
- Onto Innovation: 0.4%
- Carvana: 0.4
- e.l.f. Beauty: 0.4%
- Fabrinet: 0.3%
- Light & Wonder: 0.3%
- Weatherford International: 0.3%
- Abercrombie & Fitch: 0.3%
The Vanguard Russell 2000 ETF, like its benchmark index, has regularly underperformed the S&P 500 (SNPINDEX: ^GSPC) in recent years, as shown in the chart below.
|
Total Return |
Vanguard Russell 2000 ETF |
S&P 500 |
|---|---|---|
|
3 years |
(6%) |
38% |
|
5 years |
39% |
101% |
|
10 years |
95% |
236% |
Data source: YCharts.
Underperformance notwithstanding, Tom Lee sees the present as a turning point for small-cap stocks for two reasons. First, anticipated interest rate cuts from the Federal Reserve should benefit small-cap companies to a greater degree than large-cap companies. Second, small-cap stocks currently trade at their cheapest valuation relative to large-cap stocks in decades.
Small-cap stocks should benefit greatly from interest rate cuts
Small companies are more sensitive to interest rates than large companies. They tend to receive less favorable terms on fixed-rate loans, and they carry more floating-rate debt, which is debt with a variable interest rate tied to the economic environment. In this case, floating-rate debt has become more expensive as the Federal Reserve has raised its benchmark rate, which means the debt burden borne by small companies has become more severe.
That dynamic makes small-cap stocks especially risky investments when interest rates are rising. But it also means small-cap stocks reap outsized benefits when interest rates are falling. "Small caps have historically benefited more than large caps from the first rate cut of the cycle," according to Denise Chisholm, director of quantitative market strategy at Fidelity.
Currently, Federal Reserve policymakers are forecasting one 25-basis-point rate cut this year, and four next year. However, CME Group's FedWatch Tool shows the market expecting two 25-basis-point rate cuts this year, and at least three next year. Either scenario should give small-cap stocks a boost.
Small-cap stocks trade at their steepest discount to large-cap stocks in decades
The Russell 2000 price-to-sales ratio relative to the S&P 500 is near its lowest level in two decades, according to Bloomberg. The same is true of its forward price-to-earnings ratio (when non-profitable companies are excluded). In fact, the forward price-to-earnings ratio of small-cap stocks relative to large-cap stocks is at its lowest level since the dot-com bubble, according to Wellington Management. Put differently, the valuation gap between the two indexes is near its widest point in 25 years.
That is consequential because the Russell 2000 outperformed the S&P 500 in the aftermath of the dot-com bubble. For instance, the Russell 2000 returned 454% between 2000 and 2023, compounding at 7.4% annually. Meanwhile, the S&P 500 returned 411% during the same period, compounding at 7% annually.
Here's the bottom line: Past performance is never a guarantee of future results, and there is no guarantee the Russell 2000 will return anything close to 49% this year. However, small-cap stocks are historically cheap and they should benefit from interest rate cuts. Now is a reasonable time to allocate some money to a Russell 2000 index fund, and the Vanguard Russell 2000 ETF is an excellent option given its below-average expense ratio of 0.1%. That means the annual fee on a $10,000 portfolio would be $10. The average expense ratio on similar funds is 0.99%, according to Vanguard.
As a caveat, I would personally keep the position relatively small, such that it might represent 5% of my portfolio over time. I say that because I still have more confidence in the S&P 500 given that it tripled the return of the Russell 2000 over the last five years, and doubled its return over the last decade.
