The benchmark S&P 500 index recently reached correction territory, indicated by a 10% drop from its highs. But certain other parts of the stock market have been hit even harder.
One big area of underperformance in the recent market sell-off is small-cap stocks. The Russell 2000 small-cap index is down by more than 18% from its late-2024 peak, and to be fair, there are some good reasons. For example, there are increasing fears of a recession, and this often impacts smaller companies to a greater extent.
However, small-cap stocks looked like an excellent opportunity for long-term investors at the beginning of the year, and they look even more attractive right now. That's why the Vanguard Russell 2000 ETF (VTWO +0.33%) is at the top of my buy list right now.
What is the Vanguard Russell 2000 ETF?
As the name suggests, the Vanguard Russell 2000 ETF is an index fund that tracks the Russell 2000, which is widely considered to be the best indicator of how small-cap stocks are doing.
The median market cap of a Russell 2000 company is $3.3 billion, and although this is a weighted index, no stock makes up more than 0.6% of the fund, a sharp contrast to the mega-cap-heavy S&P 500. The fund's top holdings are Sprouts Farmers Market, Insmed, and Vaxcyte. If you aren't too familiar with any of those, that's kind of the point -- a broad small-cap ETF like this allows you to get exposure to a wide range of smaller companies without the need to research investments.
Like other Vanguard index funds, this is a very low-cost ETF, with a 0.07% expense ratio. This means that for every $10,000 you invest, your annual investment costs are just $7. (This isn't a fee you have to pay -- it will simply be reflected in the fund's performance over time.)
A wide valuation gap
The Vanguard Russell 2000 ETF was cheap a year ago and has only become even cheaper. At the start of 2024, small caps were trading for their lowest price-to-book valuation relative to their large-cap counterparts since the late 1990s. However, because of the artificial intelligence (AI)-fueled surge in mega-cap tech stocks last year, the gap only got wider. Even this year, with the S&P 500 in correction territory, the Russell 2000 has performed even worse.
This has resulted in a wide valuation gap between small-cap and large-cap stocks. Just take a look at some of the key metrics:
|
Metric |
S&P 500 Median |
Russell 2000 Median |
|---|---|---|
|
P/E ratio |
27.5 |
17.8 |
|
P/B ratio |
5.0 |
2.0 |
|
Earnings growth rate |
18.9% |
14.3% |
Data source: Vanguard. As of 1/31/2025.
This is as of Vanguard's latest data at the end of January. The gaps have widened even further since then in the recent correction. Also notice that while the typical S&P 500 stock is growing earnings faster, it's not a big enough difference to justify such a wide valuation gap.
To be fair, I don't think the gap will completely close. The S&P 500 has a disproportionate amount of high-growth (read: high-valuation) tech stocks and deserves somewhat of a premium. But this is the widest gap between the two indexes in a long time, and as I'll discuss in the next section, small caps could catch up.
Small-cap stocks could be big winners in a rebound
For one thing, while small-cap stocks have been disproportionately hit by recession fears, tariff uncertainty, and disappointing economic data, the exact opposite could be the case once these things turn around.
It's also worth noting that expectations for Federal Reserve interest rate cuts for this year have increased significantly over the past few weeks, with the median expectation now calling for three or four quarter-point rate cuts, up from an expectation of just one at the start of the year.
Small caps could be a big winner as rates fall. As a group, small caps are more reliant on borrowed money, and lower interest rates could certainly help. Plus, as rates fall, money should start coming out of things like Treasury securities and CDs and flowing into the market, which could be a big help for "riskier" stocks like small caps.
Finally, there's also the prospect of things like tax cuts and regulatory reform that are part of the Trump administration's plans. Once the dust settles on the tariff uncertainty, these could be a big boost for smaller companies.
To be perfectly clear, I have no idea if the market turbulence and correction are close to an end. If the economic data gets worse or the tariff uncertainty intensifies, just to name a few examples, things could get worse before they get better. But from a long-term perspective, the Russell 2000 ETF looks like a great opportunity right now, and I'm confident long-term investors who take advantage now will be glad they did.
