The Russell 2000 is supposed to outperform in bull markets, but that hasn't been the case recently. Since the start of 2023, the Vanguard Russell 2000 Index Fund (VTWO -0.22%) -- an exchange-traded fund (ETF) -- is up just 19% compared to a 55% gain for the S&P 500.
The small-cap index tends to outperform in bull markets because its components are more volatile and have more growth potential. However, in the current bull market, the gains have been dominated by artificial intelligence (AI) stocks such as the "Magnificent Seven," and relatively little of the spoils have gone to small-cap stocks.
With tariffs shaking up the market and the AI boom entering its next stage, that could change. Let's take a look at what would drive small-cap stocks higher and whether you should buy the Vanguard Russell 2000 Index ETF today.
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Can the Russell 2000 outperform the S&P 500?
A number of factors could drive the Russell 2000 higher. One is lower interest rates. The Russell 2000 tends to have more exposure to interest rates because many of its components are unprofitable and have proportionally more debt than large caps.
The Russell 2000 also has a significantly lower valuation than the S&P 500, with the Vanguard small-cap ETF trading at a price-to-earnings ratio of 17 versus 26 for the S&P 500. That's a significant discount for stocks that have often been more expensive than their large-cap peers. Yet, small-cap stocks typically have larger growth opportunities than large caps.
As the name indicates, the Russell 2000 holds around 2,000 stocks, so it includes a diverse mix of companies. Its top 10 holdings currently include Sprouts Farmers Market, Rocket Lab USA, and Insmed, showing a wide range of industries. As of now, 18% of the fund is in financial stocks, 17% is in the healthcare sector, and 16% is in industrials.
At the same time, the current economy is volatile, and the Russell 2000 would likely be more sensitive to a pullback than the S&P 500 even with its lower valuation. During the sell-off that followed the April 2 "Liberation Day" tariff announcement, the Russell 2000 fell further than the S&P 500, and it has also been slower to recover, as the chart below shows.
Is the Russell 2000 ETF a buy?
Over the long term, the valuation discount between the Russell 2000 and the S&P 500 should narrow, which will favor small-cap stocks, but there are other concerns about the ETF in the near term.
The Russell 2000 still has little exposure to the AI boom, which has been led by stocks like Nvidia, Microsoft, and other big tech companies. If AI spending continues to grow, the recent pattern of outperformance for the S&P 500 is likely to continue. And in spite of the recent bull market, there have been surprisingly few initial public offerings (IPOs) that could help fuel growth of the small-cap index.
Lastly, even with its lower valuation, the Russell 2000 could get hit hard by a recession since small caps tend to be more reliant on debt and can more easily slide into bankruptcy. The index outperformed in the weeks after the election as investors bet that the Trump administration would bring in a new era of deregulation and lower taxes.
Thus far, that has not happened. In fact, the trade war has sparked renewed concerns from businesses large and small, and we could soon begin to see the impact in higher prices and reduced spending.
Whether a Russell 2000 index fund is a buy for you may depend on your current portfolio. If you're heavily invested in the Magnificent Seven and the S&P 500, diversifying into small-cap stock makes sense.
On the other hand, you may have to be patient if you're hoping small caps will outperform large caps. At the moment, the Vanguard Russell 2000 ETF still faces a number of risks, including an uncertain economy, a lack of exposure to AI, and a weak IPO market.
