At the start of 2024, small cap stocks were trading for their lowest price-to-book valuations compared with their large-cap counterparts in a quarter century. And the gap has widened even further, especially as mega-cap tech stocks have continued to outperform.
In fact, while the S&P 500 is hovering around its all-time high, the Russell 2000 index is still about 18% below its 2021 peak. With that in mind, could a low-cost index fund like the Vanguard Russell 2000 ETF (VTWO -1.11%) a smart move right now?
Small cap stocks have become even cheaper
I wrote an article at the beginning of 2024 about the valuation gap between small and large cap stocks. According to Fundstrat analyst Tom Lee, small caps were trading for the lowest overall price-to-book valuations relative to the S&P 500 since 1999. And the last time the gap was this wide, small cap stocks outperformed large caps for the next 12 years.
So far, the thesis hasn't worked out, but to be fair, a lot of Lee's argument in favor of small caps assumed interest rates would start falling, which obviously hasn't happened yet. Lower interest rates could cause money to flow into the stock market and out of fixed income assets and could also boost economic growth and make it easier for small-cap companies (which tend to rely on leverage more than large caps) to borrow money at reasonable terms.
In fact, the valuation gap has widened even further. Since the start of 2024, the Vanguard S&P 500 ETF (VOO -0.52%) has risen by more than 15%. The Vanguard Russell 2000 ETF is flat for the year. If you believe that (eventually) lower interest rates will favor small caps, now looks like an even more appealing entry point.
The Vanguard Russell 2000 ETF in a nutshell
As the name suggests, the Vanguard Russell 2000 ETF is an index fund that aims to track the returns of the Russell 2000, which is the benchmark index that is widely considered to be most representative of the small-cap market as a whole.
Just like the S&P 500, the Russell 2000 is a weighted index, meaning that larger components make up a larger part of the index's performance. But because there are so many stocks in the index, and no massive outliers in terms of size, the top 10 holdings of the fund make up just about 5% of the index. In short, there's far less concentration than you'll find in the S&P.
Like most Vanguard ETFs, this one has a low expense ratio of just 0.10%, meaning that for every $1,000 in assets, $1 will go toward investment expenses every year. In short, the Vanguard Russell 2000 ETF is a great way to get small cap exposure without excessive fees or concentration in just a few stocks.
Should you buy this relatively cheap ETF today?
In full disclosure, I've been loading up on this and a couple other small cap ETFs so far in 2024, so I'm putting my money where my mouth is. However, there's no guarantee that small caps will outperform in the second half of the year, and it's entirely possible that the market will be driven by mega-caps for a few more years. The point is that while it's impossible to time the market, now looks like a solid entry point for patient long-term investors to build small cap exposure in their portfolios.
