If you look at the past few years, investors have unquestionably been focused on large caps and tech stocks. Small caps have largely been dropped from the conversation as the "Magnificent Seven" stocks and artificial intelligence (AI) dominate the market narrative.
It won't be like that forever, but will 2026 be the year we finally see that resurgence from small-cap stocks? The U.S. economy is still in pretty good shape, but there are cracks beginning to show up in a few places. That makes the environment for small caps still uncertain but one with a lot of potential if things go right.
The Vanguard Russell 2000 ETF (VTWO 2.20%) is one of the cleanest and cheapest ways to invest in this segment of the market. Let's look at the backdrop for small caps to see if now is an optimal entry point.
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What is the Vanguard Russell 2000 ETF?
The Vanguard ETF tracks the Russell 2000 index, a generally accepted measure of the performance of small-cap stocks. Its expense ratio of 0.07% makes the fund one of the least expensive in this space.
The Russell 2000 index has a much different composition than that of the tech-heavy S&P 500. Its top-five sector holdings -- healthcare, industrials, financials, technology, and consumer discretionary -- all have allocations of at least 10%, making it one of the more diverse U.S. equity indexes.
While small caps can be more volatile due to the less-established nature of the businesses, they're also more value-tilted. The Vanguard Russell ETF has a price-to-earnings ratio (P/E) of 18 compared to 28 for the Vanguard S&P 500 ETF. That discount can potentially cushion some downside risk should the economy start heading south.
Why now is the right time for the ETF
Small caps tend to be more sensitive to changes in interest rates and credit conditions. Many are much more reliant on debt and borrowing for operations compared to large caps, which usually have bigger cash balances and more access to capital.
Right now, credit conditions are relatively favorable, and borrowing can be done at modest rates. With the Fed expected to ease interest rates in 2026, borrowing costs are likely to be lower. Given the disproportionate advantage for small caps that comes with lower rates, they have a catalyst for higher stock prices.
Small caps also tend to perform better during periods of economic expansion. Over the past couple of years, the economy has been in more of a mature growth cycle that has favored just a handful of well-established mega caps.
Now, however, inflation is mostly back under control, earnings growth has been strong, interest rates are trending lower, and the growth in GDP has been accelerating. This could be the ideal set of conditions that finally broadens the market and causes investors to give small caps another look.
Why now is the wrong time for the ETF
We're starting to see signs of trouble in the labor market. The U.S. unemployment rate has risen from 4% in January to 4.6% in November. The jobs market tends to be a key driver of everything in the economy. If people lose their jobs (or believe they're at risk of it), they usually spend less. Less spending translates to lower sales and earnings for corporations and so on.
Bottom line: It's a sign that the economy may be in the early stages of a slowdown, and that's never good for stock prices.
Plus, have we really seen any evidence that investors are willing to choose small caps over large caps? The financial media is dominated by discussion of the Magnificent Seven to the point that's almost the only thing investors consider. With so much money flowing into large-cap index funds like the Vanguard S&P 500 ETF, it's almost as if small caps are trying to run with a parachute tied to their backs.
Is the Vanguard Russell 2000 ETF a buy right now?
In my opinion, it comes down to three things: earnings growth, interest rates, and tariffs. Lower rates and lower tariffs would translate right to the bottom line and be a tailwind for small caps. Those things aren't necessarily required for them to outperform, but it would sure help.
The question is whether or not small companies can generate strong earnings growth. Small caps are expected to have increased earnings by about 6% in 2025. That's less than that of the S&P 500, but they're also expected to grow by double digits in 2026 and 2027. Plus, there's a lot of value that comes with that earnings growth rate.
Given how the Russell 2000 has lagged the S&P 500 pretty consistently since the beginning of 2023, I think a comeback is in order. There are a few things that should happen in order to improve the chances of small-cap outperformance, but I'm inclined to take a chance on the Vanguard Russell 2000 ETF here.
