Market Correction: Analyzing the Vanguard Russell 2000 ETF

The S&P 500 index has recently fallen into what we call correction territory, meaning that it has dropped by 10% from its highest points. However, some segments of the stock market are not just experiencing small declines; they are suffering much larger losses.

In particular, small-cap stocks have shown significant underperformance amidst the recent sell-off in the market. The Russell 2000 index, which tracks small-cap stocks, has dropped by over 18% since reaching its peak in late 2024. This decline is partly driven by rising concerns about a potential recession, which tends to impact smaller companies more severely than larger ones.

Despite these challenges, small-cap stocks were viewed as an appealing investment opportunity at the start of the year, and they now appear even more attractive. This is why the Vanguard Russell 2000 ETF (VTWO) is currently a top choice for many investors.

Understanding the Vanguard Russell 2000 ETF

As the name suggests, the Vanguard Russell 2000 ETF is an index fund that mirrors the performance of the Russell 2000 index, which is widely regarded as a key measure of small-cap stocks in the market.

The median market capitalization of a company within the Russell 2000 is around $3.3 billion. This fund is designed to offer broad exposure to small-cap stocks, with none of the individual stocks making up more than 0.6% of its total assets. This is a significant difference when compared to the S&P 500, which is heavily weighted towards large-cap companies. The ETF's largest holdings include companies like Sprouts Farmers Market, Insmed, and Vaxcyte. If these names seem unfamiliar to you, that is intentional; a diverse small-cap ETF allows investors to gain access to many smaller businesses without needing to conduct extensive research on each investment.

Furthermore, this ETF is cost-effective, featuring a low expense ratio of just 0.07%. For an investment of $10,000, you would incur annual costs of only $7, which is not a separate fee but is reflected in the fund's overall performance.

The Valuation Discrepancy

Over the past year, the Vanguard Russell 2000 ETF appeared undervalued, and it has continued to become more affordable. At the beginning of 2024, small-cap stocks were trading at their lowest price-to-book ratios in relation to large-cap stocks since the late 1990s. Following a surge in mega-cap tech stocks driven by the AI boom, this valuation gap has only widened. Even with the S&P 500 experiencing a correction, the Russell 2000 has performed even worse.

This has created a considerable valuation difference between small-cap and large-cap stocks. Here’s how some of the key metrics compare:

Metric	S&P 500 Median	Russell 2000 Median
P/E ratio	27.5	17.8
P/B ratio	5.0	2.0
Earnings growth rate	18.9%	14.3%

The data shows that while the average company in the S&P 500 is experiencing faster earnings growth, the difference is insufficient to explain such a wide valuation gap. It’s essential to note that while the S&P 500 comprises many high-growth tech stocks that merit a premium valuation, the current gulf between small-caps and large-caps is one of the largest observed in recent times.

Potential for Small-Caps in Market Recovery

Despite being negatively impacted by fears of recession, tariff uncertainties, and weak economic data, small-cap stocks could stand to benefit significantly when these issues start to improve.

Recent trends indicate that expectations for interest rate cuts by the Federal Reserve have surged in recent weeks, with the median outlook now anticipating three or four cuts this year. This is a positive sign for small-cap stocks, which typically rely more on borrowing. Lower interest rates could ease financial pressures, making it cheaper for these companies to operate. Additionally, as rates fall, investor interest may shift from safe investments like Treasury securities to riskier assets like small-cap stocks.

Moreover, proposals for tax reductions and regulatory changes that could benefit smaller enterprises are also part of the current political landscape. Once the uncertainties surrounding tariffs clear, these initiatives could provide a significant boost to small-cap companies.

While it is uncertain whether the market turbulence will settle soon, the Russell 2000 ETF presents a compelling opportunity for long-term investors. Those who seize this moment may find their investments rewarding in the future.

This article is for informational purposes and does not constitute financial advice.

Market, ETF, Investing