Market Correction: A Look at the Vanguard Russell 2000 ETF

The S&P 500 index has recently entered a correction, which is marked by a 10% decline from its previous highs. However, some market segments have experienced even greater losses. One significant area that has seen poor performance during this market downturn is small-cap stocks.

Taking a closer look, the Russell 2000 small-cap index has dropped by more than 18% from its high in late 2024. This sharp decline is not without reasons, as rising concerns about a potential recession tend to adversely affect smaller companies more than larger firms.

Despite this downturn, small-cap stocks seemed like a compelling opportunity for long-term investors at the beginning of the year, and they look even more appealing now. This is why the Vanguard Russell 2000 ETF (VTWO) is currently a strong contender for my investment list.

Understanding the Vanguard Russell 2000 ETF

The Vanguard Russell 2000 ETF, as its name indicates, is an index fund that aims to replicate the performance of the Russell 2000 index. This index is widely respected as a benchmark for small-cap stocks.

The median market capitalization of the companies listed in the Russell 2000 is about $3.3 billion. Although this index is weighted, the largest stock only constitutes about 0.6% of the total fund, distinguishing it sharply from the larger-cap S&P 500 which is heavily influenced by few mega-stocks. Major holdings in the fund include Sprouts Farmers Market, Insmed, and Vaxcyte. If you're not familiar with these companies, that’s part of the advantage of investing in a diverse small-cap ETF – it provides exposure to many smaller firms without requiring individual stock research.

Like other Vanguard index funds, this ETF comes with a competitive price tag, featuring a low expense ratio of just 0.07%. This means if you invest $10,000, your annual cost is merely $7—an insignificant fee compared to potential returns.

Valuation Gap in the Market

A year ago, the Vanguard Russell 2000 ETF was already a bargain, and it has only become cheaper since then. At the start of 2024, small-cap stocks were valued at their lowest compared to large caps since the late 1990s. The recent surge in mega-cap technology stocks, fueled by the hype around artificial intelligence (AI), has widened this valuation gap further, with the Russell 2000 lagging behind even as the S&P 500 faced corrections.

This trend has led to an increasingly pronounced difference in valuations between small-cap and large-cap stocks. Key metrics paint a clear picture:

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%

This data reflects the situation as of January 31, 2025, and the disparities have grown even larger since then amid the recent market correction. While S&P 500 companies display faster earnings growth, the difference is not significant enough to warrant such a wide gap in valuations.

It is worth mentioning that the gap is not expected to completely close. The S&P 500 consists largely of high-growth technology stocks, justifying a degree of premium. However, the current valuation gulf between the two indices is at its widest in years, suggesting that small caps could rebound strongly.

Opportunity Ahead for Small-Cap Stocks

Although small-cap stocks have been disproportionately affected by concerns regarding recession, trade uncertainties, and lackluster economic indicators, the landscape could change dramatically as these factors improve.

Additionally, expectations for interest rate cuts by the Federal Reserve have risen significantly recently, with projections now suggesting three or four quarter-point cuts this year, compared to initial expectations of just one cut.

Lower interest rates could prove beneficial for small-cap stocks, which typically rely more on borrowing. As rates decrease, funds might shift from safer investments like Treasury securities into the stock market, potentially benefiting riskier stocks like small caps.

Moreover, factors like tax cuts and regulatory reforms being discussed could present significant advantages for smaller companies once the trade uncertainties resolve.

While it remains uncertain whether the current market turbulence will resolve soon, from a long-term standpoint, the Russell 2000 ETF is presenting a compelling opportunity. Long-term investors who choose to seize this moment may find themselves well-rewarded.

Market, Correction, Investing