The S&P 500 and Nasdaq are within a couple percentage points of their all-time highs, and many popular stocks and ETFs are looking rather expensive right now. That's especially true about some of the mega-cap technology stocks, and the funds that are heavily weighted in favor of the largest companies in the market.
However, there are some areas of the market that are still relatively cheap, and two that are worth a closer look are small-cap stocks and real estate investment trusts, or REITs (pronounced 'reets'). Investors who are looking for bargains in the generally expensive stock market may want to take a closer look at the Vanguard Russell 2000 ETF (VTWO 1.94%) and the Vanguard Real Estate ETF (VNQ 1.01%), as both look like excellent opportunities for patient long-term investors to put money to work.
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2 Great Vanguard ETFs
The Russell 2000 is the most widely followed index of small cap stocks, and the Vanguard Russell 2000 ETF allows investors to track its performance. As the name suggests, the index consists of the stocks of 2,000 companies, and they have a median market cap of $3.4 billion. Although it's a weighted index, because of the number of stocks and small-cap nature of the fund, no stock accounts for more than 0.74% of its assets. In short, this is a highly diversified basket of smaller companies.
On the other hand, the Vanguard Real Estate ETF invests in an index of real estate investment trusts (REITs). These are companies that own retail properties, data centers, office buildings, apartments, warehouses, and other types of commercial real estate.
Unlike the Russell 2000 ETF, the Vanguard Real Estate is somewhat concentrated in its largest positions. The fund owns over 150 stocks, but the 10 largest holdings make up 39% of the total assets -- essentially, there are some REITs that are much larger than the average company in the sector.
Because REITs are designed as income investments, the Vanguard Real Estate ETF is an excellent dividend ETF. It passes through the dividends paid by its components, and has a yield of nearly 4%.
Why now?
The short explanation of why now could be a great time to buy these two ETFs is there's a valuation gap between small cap and large cap stocks, and the likely falling-rate environment of the next couple of years could disproportionately benefit small caps and rate-sensitive sectors like real estate.
Just to put some context behind this, consider that the average Russell 2000 component trades for 2.0 times book value as of the latest information, and has a price-to-earnings ratio of 18.3. Meanwhile, the average S&P 500 component trades for 5.2 times book value and nearly 29 times earnings.
This is the largest valuation gap since the late 1990s. And small cap stocks proceeded to outperform large caps for more than the next decade.
As far as interest rates go, the benefits on REITs are plentiful. First, REITs generally rely on borrowed money to grow (similarly to how most homebuyers rely on mortgages), and lower rates mean lower borrowing costs. Second, commercial real estate values are directly correlated with risk-free interest rates (the 10-year Treasury yield tends to be a good indicator), so lower rates can make their properties more valuable. And finally, when rates fall, dividend yields tend to fall as well. Since stock price and yield have an inverse relationship, falling yields can push REIT share prices higher.
Buy and never sell -- and then buy more
Although I think it could be an opportune time to add both of these ETFs to your portfolio, I want to be clear that I'm suggesting these as long-term investments. Buying at an attractive valuation and holding for decades can be a great way to build wealth over time, and that's exactly why I own both of these ETFs in my portfolio and add shares regularly.
