In the foreseeable future, a Wall Street analyst predicts that the Vanguard Index Fund could outperform the S&P 500 by an impressive 100%.
Generally speaking, the S&P 500 (^-GSPC 0.00%) is usually the go-to indicator for large-cap companies in the stock market, while the Russell 2000* takes that role for small-cap businesses. More specifics are provided below:
- S&P 500: This includes 500 large-cap companies, making up approximately 80% of the U.S. equity market by market value. The median market cap here is around $37 billion.
- Russell 2000: This includes nearly 2,000 small-cap companies, accounting for around 5% of the U.S. equity market by market value. The median market cap for this group is approximately $1 billion.
During a recent interview with CNBC, Tom Lee, head of research at Fundstrat Global Advisors, expressed his belief that small-cap stocks might trump large-cap stocks by a significant margin in the near future. He stated, "I think small caps, in the next couple of years, could outperform by more than 100%." Lee attributed this prediction to interest rate decreases and historically inexpensive valuations.
Should this forecast materialize, the Russell 2000 could potentially leave the S&P 500 in its dust in the coming years, even doubling its return as suggested by Lee. Investors can take advantage of this situation by purchasing shares in the Vanguard Russell 2000 ETF (VTWO-0.66%).
Let's dive deeper into why the Russell 2000 might excel.
The Russell 2000's Strong Winds of Support
Tom Lee pointed out two reasons why small-cap stocks could outperform in the coming years. First, the Federal Reserve has begun reducing interest rates, and small-cap companies tend to benefit more from rate cuts than large-cap companies thanks to their higher proportion of floating-rate debt. Second, small-cap stocks are currently sporting historically cheap valuations compared to their large-cap counterparts.
It's worth mentioning that Tom Lee isn't the only Wall Street prognosticator to make such claims. In July, JPMorgan Chase strategist Michael Cembalest wrote, "Small-cap stocks are at their lowest valuations in the 21st century with favorable market and political catalysts." He cited decreased interest rates and the tariffs proposed by President-elect Donald Trump as potential catalysts, as tariffs generally impact large-cap stocks more.
Likewise, Goldman Sachs strategists Hania Schmidt and Jen Nusser touched on interest rate cuts and small-cap valuations in a recent blog entitled: It's Time to Shine? A Small Cap Reversal of Fortune. Below is a summary of their key points:
- Historically, the Russell 2000 outperforms the S&P 500 by an average of 12 percentage points during the 12-month period following the end of a rate-cutting cycle.
- Since 1985, the median P/E ratio of the Russell 2000 stock has been (on average) 2% below that of the median S&P 500 stock. However, the disparity currently stands at 28%.
By the way, the current rate-cutting cycle commenced in September and is expected to last for several months. Consequently, the first point mentioned above will only become relevant once the current rate-cutting cycle concludes. That said, the valuation disparity between the Russell 2000 and the S&P 500 is currently 26 percentage points below its average over the past four decades.
The Vanguard Russell 2000 ETF Offers Access to Small-Cap Stocks
The Vanguard Russell 2000 ETF mirrors the performance of approximately 2,000 small-cap companies and includes both growth and value stocks across all 11 market sectors. Despite being largely focused on the industrial, financial, and healthcare sectors, it has the least market value in technology stocks compared to the S&P 500, which is weighted significantly more towards technology.
The top five position holders in the Vanguard Russell 2000 ETF are listed below by weightage:
- FTAI Aviation: 0.5%
- Sprouts Farmers Market: 0.5%
- Vaxcyte: 0.5%
- Insmed: 0.4%
- Mueller Industries: 0.3%
It's noteworthy that the Russell 2000 offers less exposure to technology stocks than the S&P 500, which has 32% of its market value in technology stocks. This distortion is significant because the technology sector was the top-performing sector in the past five, ten, and twenty years.
Consequently, the Vanguard Russell 2000 ETF lagged behind the S&P 500 during those periods. In fact, while the Vanguard Russell 2000 ETF increased around 125% over the past decade, the S&P 500 surged approximately 245%, essentially doubling the return of the small-cap benchmark.
Lastly, the expense ratio of the Vanguard Russell 2000 ETF stands at a modest 0.1%, compared to the Vanguard S&P 500 ETF's 0.03%.
In summary, Tom Lee, from Fundstrat Global Advisors, predicts that small-cap stocks will outperform large-cap stocks by more than 100% in the near future, thanks to interest rate cuts and historically low valuations. Investors can capitalize on this predicted outperformance by purchasing shares of the Vanguard Russell 2000 ETF.
In recent times, the S&P 500 has outperformed the Russell 2000 largely due to its higher concentration in tech sectors. This trend might persist as the world of artificial intelligence expands. Therefore, I recommend investing in both an S&P 500 ETF and a Russell 2000 ETF, but I'd suggest focusing more on the former compared to the latter.
Given the predictions of Tom Lee and other Wall Street analysts, investors might consider diversifying their portfolios by looking into both large-cap and small-cap stocks. Specifically, if Lee's forecast about small-cap stocks outperforming large-cap stocks materially comes to pass, investing in the Russell 2000 could result in significant financial gains. Additionally, considering the potential benefits of owning small-cap companies with a higher proportion of floating-rate debt when interest rates decrease, evaluating finance options that include these companies may be prudent for individuals engaged in investing.
