The S&P 500, a key benchmark for the stock market, recently entered correction territory, having dipped 10% from its previous high. However, other areas have faced even steeper declines, particularly small-cap stocks. The Russell 2000 index, which tracks these smaller players, has tumbled over 18% from its peak in late 2024. The sell-off can largely be attributed to mounting recession fears, which tend to hit smaller companies harder.
Despite this downturn, the landscape for small-cap stocks is beginning to look promising for long-term investors. At the start of the year, small caps appeared as a particularly attractive sector, and they are even more appealing at this point. This perception is precisely why the Vanguard Russell 2000 ETF (VTWO, with a recent increase of 2.44%) is currently a compelling buy on my list.
So, what exactly is the Vanguard Russell 2000 ETF? As its name suggests, this is an index fund that mirrors the performance of the Russell 2000, a benchmark for small-cap stocks. The median market cap of companies in the Russell 2000 is about $3.3 billion. While it is a weighted index, no single stock constitutes more than 0.6% of the fund, which is notably different from the mega-cap-heavy S&P 500. Its top holdings include companies like Sprouts Farmers Market, Insmed, and Vaxcyte. If those names aren’t immediately familiar to you, it underscores the ETF’s strength: it offers exposure to a vast array of smaller companies, minimizing the need for extensive individual research.
In line with other Vanguard index funds, this ETF is cost-effective, featuring a 0.07% expense ratio. Essentially, for every $10,000 invested, yearly costs amount to just $7, which isn’t an upfront fee; rather, it’s reflected in the fund’s ongoing performance.
Looking at the valuation landscape, the Vanguard Russell 2000 ETF was already a bargain a year ago and has become even more so. At the start of 2024, small-cap stocks traded at their lowest price-to-book valuation when compared to large caps since the late ’90s. The surge in mega-cap tech stocks driven by AI last year only widened this valuation gap. This year, even with the S&P 500 correction, the Russell 2000’s performance has lagged even further.
The result is a pronounced valuation disparity between small and large-cap stocks. For instance, comparing key metrics reveals the following: the S&P 500 has a median P/E ratio of 27.5, while the Russell 2000 sits at 17.8. The price-to-book ratio for the S&P is 5.0, against 2.0 for the Russell. True, the typical S&P stock shows slightly faster earnings growth at 18.9% compared to the Russell’s 14.3%, but this doesn’t fully justify the valuation gap.
While it’s unlikely that this gap will completely close—given the S&P 500’s dominance of high-growth tech stocks deserving a premium—it remains the widest it has been in years. This presents an opportunity for small-caps to potentially play catch-up.
Small-cap stocks could shine if the market rebounds. They’ve been hit hard by recession anxieties, trade tensions, and lackluster economic indicators, but a positive reversal in these conditions could particularly benefit them. Expectations for Federal Reserve interest rate cuts have climbed, with forecasts now suggesting three to four quarter-point reductions, a significant jump from just one predicted earlier in the year. Falling interest rates would be a boon for small caps, which are more dependent on borrowing. This scenario would likely redirect capital from safer investments, such as Treasury securities, into more dynamic stock market opportunities, benefiting risk-tolerant small caps.
Moreover, the possibility of tax cuts and regulatory changes under the Trump administration may also bolster smaller companies once trade uncertainties dissipate.
Of course, the future isn’t entirely predictable. If economic indicators falter or trade tensions escalate, market volatility and corrections might persist. Nonetheless, from a long-term perspective, the Russell 2000 ETF presents a compelling opportunity. I’m confident that investors with patience and foresight who act now will find themselves rewarded in the years to come.
