Fundstrat analyst Tom Lee in November told CNBC that small-cap stocks are positioned to crush the S&P 500 (SNPINDEX: ^GSPC) due to relatively cheap valuations and interest rate cuts. “I think small caps, in the next couple of years, could outperform by more than 100%,” he predicted.
History supports the notion that small-cap stocks are headed for a period of outperformance. The small-cap Russell 2000 returned an average of 45% during the 12-month period following the last five rate-cut cycles. Meanwhile, the S&P 500 gained an average of 33%, according to Goldman Sachs.
The Federal Reserve started lowering interest rates in September, but policymakers left rates unchanged in January. That does not necessarily mean the cutting cycle is over, but the downward trend is still good news for the small-cap Russell 2000. Investors can capitalize on its potential outperformance by owning shares of the Vanguard Russell 2000 ETF (NASDAQ: VTWO).
Here are the important details.
The Russell 2000 tracks approximately 2,000 small-cap companies that cover 5% of U.S. stocks by market value. The index includes companies from all 11 market sectors, but leans most heavily toward industrials (19%), financials (18%), and healthcare (16%). That differs from the S&P 500 which is most heavily weighted toward the technology sector.
The Vanguard Russell 2000 ETF provides exposure to the Russell 2000. The five largest holdings in the index fund are listed by weight below:
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FTAI Aviation: 0.5%
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Sprouts Farmers Market: 0.4%
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Insmed: 0.4%
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Vaxcyte: 0.3%
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Credo Technology Group: 0.3%
Importantly, the Vanguard Russell 2000 ETF has an expense ratio of 0.1%, which means shareholders will pay $1 annually on every $1,000 invested in the fund.
Small-cap stocks have underperformed large-cap stocks in recent years. The Russell 2000 returned 123% over the last decade, but the S&P 500 gained 258% during the same period. One reason for that underperformance is that small-cap companies can graduate from the Russell 2000. In other words, the better a small-cap stock performs, the more likely it is to outgrow the limits of the Russell 2000 and be added to the S&P 500.
Another reason the Russell 2000 underperformed during the last decade is its limited exposure to technology stocks. The technology sector absolutely crushed the other stock market sectors over the last 10 years, more than doubling the return of the next closest contender, which was consumer discretionary sector.
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