The Russell 2000 is a widely followed benchmark index that tracks approximately 2,000 of America's smallest publicly listed companies. The index has experienced a significant surge in value, gaining 10.3% since the beginning of July compared to the S&P 500, which has remained flat since the same date. A key factor driving this upward trend is the expectation that the U.S. Federal Reserve will cut interest rates multiple times before the end of 2024 due to favorable economic indicators, including inflation and unemployment figures. Investors looking to capitalize on this potential trend should consider an exchange-traded fund (ETF) designed to track the performance of the Russell 2000 index. 

Vanguard and the Russell 2000 Index

The Vanguard Russell 2000 ETF (NASDAQ: VTWO) is designed to closely track the performance of the Russell 2000 Index by investing in the same companies with similar weighting. It provides investors with a diversified and convenient method of gaining exposure to the small-cap sector. 

VTWO boasts a substantial market capitalization exceeding $9.5 billion, symbolizing its significance within the exchange-traded fund (ETF) market. Vanguard Russell’s dividend yield of 1.31% represents an attractive income stream for investors seeking dividend-paying securities. 

Furthermore, VTWO exhibits significant liquidity, with an average daily trading volume of 2.4 million shares, enabling investors to enter and exit their positions quickly. This high liquidity enhances the ETF's attractiveness to individual and institutional investors.

While the S&P 500 represents a broad range of the US economy across 11 sectors, it is heavily weighted towards technology, with a 32.4% allocation. The Russell 2000 presents a more balanced approach, with the industrial sector comprising 19%, healthcare at 15.2%, and financials at 14.8% (the three largest of its 12 sectors).

Although numerous companies in the Russell 2000 index might not be widely recognized, notable established businesses are among its holdings. Tenable (NASDAQ: TENB), a leader in vulnerability management cybersecurity software, and Axcelis Technologies (NASDAQ: ACLS), which manufactures essential equipment for the semiconductor sector in the artificial intelligence (AI) space, are notable examples. Redfin (NASDAQ: RDFN), a real estate technology company, is also included in the Russell 2000, and its stock has experienced significant gains recently as investors anticipate the impact of future interest rate cuts on the housing market. Additionally, Krispy Kreme (NASDAQ: DNUT) and dating platform Bumble (NASDAQ: BMBL) are recognizable brands within the index.

The Impact of Interest Rate Cuts on Small-Caps

Current indications are that the Federal Reserve may reduce interest rates several times before the end of 2024. This potential shift in monetary policy is expected to lower the yield on risk-free assets like cash deposits and treasury bonds, prompting investors to allocate their capital towards growth assets, such as stocks and real estate.

This trend can particularly benefit the Russell 2000, as smaller companies often rely on financing to fuel their growth and typically have a higher proportion of floating-rate debt directly impacted by interest rate changes. Small caps will likely experience increased borrowing power as interest rates decline, leading to lower interest payments and potential earnings growth.

Moreover, the Russell 2000 is currently valued at a price-to-earnings (P/E) ratio of 16.9, representing a 28.3% discount compared to the S&P 500's P/E ratio of 23.6. This suggests that small caps are trading at a significantly cheaper valuation than their larger counterparts.

The Long-Term Perspective: Russell 2000 vs. S&P 500

Despite the Russell 2000's potential for strong future returns, investors should maintain realistic expectations regarding its ability to outperform the S&P 500 consistently. Since its inception in 2010, the Vanguard Russell 2000 ETF has generated a compound annual return of 9.9%, while the S&P 500 has realized a higher average yearly gain of 13.7% over the same period.

This disparity in annual returns, amounting to a 3.8 percentage point difference, significantly impacts long-term investment performance, demonstrating the compounding effect of even seemingly minor differences in return rates. For example, an initial investment of $10,000 in the Vanguard Russell 2000 ETF in 2010 would have grown to $37,494 by 2024, while the same investment in the S&P 500 would have reached $60,345, highlighting the substantial advantage of higher returns over extended periods.

The S&P 500's stringent inclusion criteria ensure that only companies demonstrating exceptional financial health and strong earnings power are included. Notable examples include Nvidia (NASDAQ: NVDA) and Apple (NASDAQ: AAPL), which possess exceptional earning capabilities that are difficult to replicate for companies within the Russell 2000. Consequently, investors often pay a premium for this demonstrably higher quality, resulting in the S&P 500 consistently trading at a significant premium to the Russell 2000, as reflected in their price-to-earnings ratios.

Small-Caps Catch Up: A Recent Market Shift

Tech stocks have recently been a drag on the S&P 500 and the Nasdaq 100; both indexes have fallen to their lowest level since early June. This downward trend is particularly notable as it follows two months of solid performance. The Nasdaq 100 had gained 23% year-to-date ahead of June's Consumer Price Index reading. Still, after the index registered its first monthly drop in inflation since 2020, investors triggered a swift rotation away from large-cap stocks and towards smaller companies.

The Nasdaq 100 has since surrendered half of those gains, surprising many investors now witnessing the Russell 2000 index catching up to the tech-heavy index. This dramatic shift in market leadership is evident in the stark contrast between June and July. In June, the Nasdaq outperformed the Russell 2000 by over seven percentage points, while in July, the Russell 2000 outperformed the Nasdaq by nearly fourteen percentage points, marking the most significant month-to-month flip in leadership since 1988.

Small-cap stocks have consistently underperformed large-cap stocks over the past decade. Since July 2014, the Russell 2000 has returned 126%, while the S&P 500 has generated a 232% return. This disparity has resulted in the Russell 2000 trading at its steepest discount to the S&P 500 in decades.

The Russell 2000, a benchmark index tracking the performance of approximately 2,000 small-cap companies, is experiencing a significant surge in value, partly driven by the anticipation of interest rate cuts. The Vanguard Russell 2000 ETF offers investors a viable option to gain exposure to this sector, which presents a unique opportunity for growth. While the Russell 2000 may not consistently outperform the S&P 500, its historically cheap valuations and the potential benefits of interest rate cuts make it a compelling investment consideration.