The S&P 500 deservedly gets all the attention, as the index has a total market capitalization of $57 trillion. However, investors need to realize that there is a sea of other companies on the other end of the spectrum that are much smaller than the businesses you're familiar with.
Here's where the Russell 2000 comes into the picture. Owning an exchange-traded fund (ETF), such as the Vanguard Russell 2000 ETF (VTWO +1.26%), could provide investors with adequate exposure in their portfolios to different areas of the stock market.
Should investors buy this ETF right now?
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Investors should understand where their money goes
The Vanguard Russell 2000 ETF tracks the performance of the Russell 2000 Index, a prominent index following small-cap stocks. The top sector by weighting is industrials at 18.9%. This is a major differentiator compared to funds that track the S&P 500, which has 34.8% of assets in the information technology sector. In fact, technology is only the fourth-largest sector in the Vanguard Russell 2000 ETF.
The monster successes of businesses like Nvidia, Apple, and Microsoft have driven the overall stock market. The Vanguard Russell 2000 ETF, unfortunately, doesn't own these companies. This means that investors don't get to benefit from the incredible artificial intelligence boom that started three years ago and is showing no signs of slowing down.
This ETF provides broad diversification, though. The largest holding, Credo Technology Group, accounts for only 0.74% of the portfolio's asset base. The top 10 positions make up less than 5% of the ETF. A single stock blowing up won't put a dent in the performance.
The Vanguard Russell 2000 ETF has lagged the S&P 500
In the past decade, the Vanguard Russell 2000 ETF has generated a total return of 148% (as of Oct. 21). Had you invested $10,000 in October 2015, you'd have $24,760 today. That's a respectable gain. However, this performance comes up significantly short of the S&P 500. This index has produced a total return of 295% over the last 10 years.
It's worth mentioning the cost of owning this ETF. The Vanguard Russell 2000 ETF carries an expense ratio of 0.07%. That's a very low price, allowing investors to keep more of their capital over time.
Perhaps investors believe that now might be a good time to invest and that returns going forward will be better. One reason comes down to valuation. The weighted average price-to-earnings ratio of the S&P 500 was 28.9 as of Sept. 30. For the Russell 2000, it's only 18.3. To be fair, the bigger index has seen its companies grow their profits at a faster clip, but some investors might think the smaller index deserves a higher valuation.
Betting on small-cap companies means being bullish on the overall economy, particularly just in the U.S., as most of these businesses might not have an international presence. The start of ongoing interest rate cuts by the Federal Reserve might be a catalyst for these kinds of stocks. Lower interest rates will not only help these companies raise debt financing on more favorable terms, but they could also lead to greater risk-taking by the investment community.
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Key Data Points
Investors should build a diversified portfolio
It's impossible to know when small-cap stocks will have their time to shine. The necessary tailwinds might be in place for stronger returns. But the trailing 10-year performance isn't encouraging.
That being said, owning the Vanguard Russell 2000 ETF might make sense as part of a well-diversified portfolio. Investors shouldn't allocate the bulk of their assets to this single investment vehicle because then they'd be missing out on the performance of the world's most dominant companies. However, it could be a good idea to have some exposure to small caps.
