Small-cap stocks are off to scintillating starts this year, with the widely followed Russell 2000 index climbing 5.31% in January. Obviously, that's good news for the various exchange-traded funds (ETFs) tracking that gauge, including the Vanguard Russell 2000 ETF (VTWO 2.20%).
In even better news, the prevailing sentiment on Wall Street is that smaller stocks can keep the good times going this year due to a variety of factors, including expectations of economic growth, declining interest rates, and earnings growth that beats those of their large-cap counterparts.
This small-cap ETF is decent, but there are better options from the same issuer. Image source: Getty Images.
The state of the U.S. economy is material to this Vanguard fund because smaller companies are usually more domestically focused than their bigger rivals. As for lower interest rates, that would be an assist for this ETF because many small-cap firms need to borrow capital to fund growth objectives. Lower interest rates equal a lower cost of that capital. All that sounds good as it relates to this ETF, and it is, but investors should be selective with small-cap ETFs.
This ETF is fine, but investors can do better
The Russell 2000-tracking ETF isn't the only small-cap blend ETF in the Vanguard stable, and from the perspective of some experts, it's not the best of the issuer's batch of those products. It's actually not even the second-best as measured by 15-plus years of performance.
Let's focus on the competition with the Vanguard S&P SmallCap 600 ETF (VIOO 1.81%), the light blue line in the chart above. As their names imply, the Russell 2000 tracker and that ETF are index funds, but they follow different indexes. Admittedly, index "nerdery" isn't everyone's cup of tea, so this will be a quick lesson.
Entering 2025, the S&P small-cap index beat the Russell 2000 in 20 full calendar years through the end of 2024. The reason for that outperformance essentially boils down to the S&P gauge requiring new additions to have a history of positive earnings. The Russell index doesn't feature that mandate.
This doesn't mean the Vanguard Russell 2000 ETF is damned to perpetual underperformance. There are periods, some measured in years, when junky small caps beat higher-quality peers, but some investors may not want to bank on that trend over the long haul.
And speaking of "junky," or not turning profits, before the 2008 global financial crisis, just 27% of the Russell 2000 was comprised of unprofitable firms. That figure vaulted to 46% as of December, according to J.P. Morgan Asset Management. This implies that 908 of the Vanguard Russell 2000's 1,974 holdings aren't making money. That's a lot.
Not all bad news with this ETF
To be fair, the Vanguard Russell 2000 small-cap ETF has some pluses. As noted above, it holds nearly 2,000 stocks, providing investors with a broad approach to domestic small-cap equities, and none of those holdings exceed a weight of 0.74%, confirming that single-stock risk is essentially nonexistent.
Additionally, this ETF's expense ratio is just 0.06% annually, or $6 on a $10,000 investment. That's way below the 0.97% average on similar funds. Indeed, there are some things to like about this ETF, but selective investors can do better elsewhere with the Vanguard S&P SmallCap 600 ETF.
