Last November, Fundstrat analyst Tom Lee told CNBC that small-cap stocks are headed for a prolonged period of outperformance compared to the large-cap S&P 500 (^GSPC -0.39%). "I think small caps could, in the next couple of years, outperform by more than 100%," Lee said.
The opposite has actually happened since he made that prediction. The Russell 2000, a benchmark for small-cap stocks, has tumbled 16%, while the S&P 500 has declined only 8%. However, the investment thesis Lee outlined late last year remains compelling.
Here's what investors should know.
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The bull case for small-cap stocks in the current market environment
The small-cap Russell 2000 achieved a total return of 7% in the last three years, dramatically underperforming the 40% return in the large-cap S&P 500. But Tom Lee thinks that trend could reverse in the years ahead as small-cap stocks benefit from lower interest rates and more attractive valuations.
The Federal Reserve began lowering its benchmark interest rate in September. That should asymmetrically benefit small-cap companies because they have more floating-rate debt. Indeed, the Russell 2000 returned an average of 45% during the 12-month period following the last five rate-cut cycles, while the S&P 500 returned an average 33%, according to Goldman Sachs.
The Russell 2000 trades at 16 times earnings, and earnings are forecast to grow at 11.5% annually in the next few years, according to Morningstar. Those figures give a price/earnings-to-growth ratio (PEG) of 1.4. Meanwhile, the S&P 500 trades at 22 times earnings, and earnings are forecast to grow at 9.4% annually in the next few years. Those numbers give a less attractive PEG of 2.3.
Lastly, Russell 2000 companies derive one-fifth of sales from outside the U.S., while S&P 500 companies derive one-half of sales from outside the U.S. Because small-cap companies are less dependent on international revenue, they are less sensitive to retaliatory tariffs that may be levied on U.S. exports. It also means they are less sensitive to a stronger U.S. dollar, which may be a consequence of the U.S. imposing tariffs on imported goods.
The Vanguard Russell 2000 ETF provides exposure to small-cap stocks
The Russell 2000 tracks about 2,000 small-cap companies that cover about 5% of U.S. stocks by market value.
The index includes companies from all 11 market sectors, but it leans most heavily toward the industrial (19%), financial (19%), and healthcare (17%) sectors. Comparatively, the S&P 500 is weighted heavily toward the information technology (31%), financial (14%), and consumer discretionary (11%) sectors.
The Vanguard Russell 2000 ETF (VTWO -0.02%) provides investors with exposure to the Russell 2000. The five largest holdings in the index fund are listed by weight below:
- Sprouts Farmers Market: 0.6%
- Insmed: 0.5%
- Vaxcyte: 0.4%
- SouthState: 0.4%
- FTAI Aviation: 0.4%
The Vanguard Russell 2000 ETF has an expense ratio of 0.07%, which means shareholders will pay $0.70 annually on every $1,000 invested in the fund. The expense ratio on similar funds is 0.98%, according to Vanguard.
Here's the bottom line: Recent interest rate cuts, relatively cheap valuations, and the trade war initiated by the Trump administration could lead to small-cap outperformance in the years ahead. The Vanguard Russell 2000 ETF is a sensible way for investors to position their portfolios for that possible outcome.
However, investors should bear in mind that large-cap stocks have crushed small-cap stocks in recent history. So, I would personally keep my position in the Vanguard Russell 2000 ETF relatively small. And I certainly would not abandon any high-conviction large-cap stocks, nor would I abandon my S&P 500 index fund.
