Small-cap outperformance in recent years has been a rare thing. The Russell 2000 index has only beaten the S&P 500 (^GSPC +0.93%) once since 2017. That was in 2020 and it only outperformed by about 1.5 percentage points.
Now may be the time to start thinking about small caps differently and consider them for some of the best exchange-traded funds (ETFs) to buy.
The past three years have been all about dominance from U.S. mega-cap growth and tech stocks. The leadership has been so strong that almost every other sector has lagged behind the S&P 500 during that time. A lot of people think the artificial intelligence (AI) boom will keep the streak going. History says it probably won't. Five straight years of small caps lagging behind large caps is very rare and they're long overdue for a return.
Image source: Getty Images.
Where does the 45% number come from? That translates to an average annual return of about 13%. That's a reasonable target for a segment that has some strong value built in and is in the very early stages of an investor rotation into it.
It also represents returns the index has seen in past three-year recovery cycles. Here are some examples from the past quarter-century.
- 2003-2005: 75%
- 2009-2011: 48%
- 2016-2018: 19% (although it was up 49% through the end of Q3 2018 before the bear market in Q4 set in)
The new year has gotten off to a good start for the Russell 2000. If the outperformance trend is just getting started, here are three ETFs that will help capture it.
iShares Russell 2000 ETF
The iShares Russell 2000 ETF (IWM +2.20%) is probably the most common representation of the small-cap market. It invests in the next 2,000 stocks ranked by market cap after the 1,000 stocks included in the large-cap Russell 1000 index.
NYSEMKT: IWM
Key Data Points
One of my common gripes about the Russell 2000 is that it includes so many unprofitable companies. Right now, about 40% of the index's components are losing money. That's not really a recipe for long-term success, but it's one that can be favorable under the right conditions in the short term.
Riskier companies often underperform when conditions turn south, but they frequently outperform during the better times, even though their balance sheets aren't in the best shape. Since "Liberation Day" in April 2025, when President Donald Trump unveiled a raft of tariffs on U.S trade partners, unprofitable Russell 2000 components have outperformed profitable ones by about 20%.
If the tailwinds of lower rates, stable inflation, and earnings growth are there, this fund's lower quality profile could actually lead the market higher.
iShares Core S&P Small-Cap ETF
The iShares Core S&P Small-Cap ETF (IJR +1.75%) helps address the Russell 2000's quality issue. If your goal is to invest in small caps but you want to stick with the ones that are in better shape financially, you may prefer this fund to a Russell 2000 ETF.
NYSEMKT: IJR
Key Data Points
This ETF tracks the S&P SmallCap 600 index. As the name suggests, it invests in the 600 largest companies after those in the S&P 500 and the S&P MidCap 400 index.
The reason this ETF works is because the index has a profitability requirement. Qualifying companies must have positive earnings in the most recent quarter and positive cumulative returns during the past four quarters.
That makes it slightly less volatile than the Russell 2000 and it has better quality metrics, including return on assets (ROA) and return on equity (ROE). It's also likely to narrow the range of potential returns due to the quality component.
Vanguard Small-Cap Value ETF
The Vanguard Small-Cap Value ETF (VBR +1.60%) is worth considering if you want to tilt a little further into undervalued companies.
NYSEMKT: VBR
Key Data Points
This fund starts with a broad small-cap universe and then pulls out stocks based on several valuation metrics and a cash-flow yield. That last measure helps give it a quality tilt that is necessary when investing in this market segment. Many small-cap value stocks trade at discounts for a reason. They're losing money or their future prospects don't look good. Taking cash flow yield into consideration helps weed out some of the bad apples.
There's not a great deal of value at the moment. The portfolio still trades at about 17 times earnings. But there is potential if these stocks get swept up in a market rebound.
