A Russell 2000 Bull Market Is Coming: 1 Unstoppable Vanguard ETF to Buy Hand Over Fist

The Russell 2000 features approximately 2,000 of America's smallest listed companies. At Tuesday's close, the index has surged by a whopping 10.3% since July 1, crushing the widely followed S&P 500, which is trading flat since then.

Investors are predicting the U.S. Federal Reserve will cut interest rates three times before the end of 2024 thanks to favorable inflation and unemployment data. Rate cuts can benefit small companies significantly more than their larger peers, and I'll explain why in a moment.

Despite the strong gain in the Russell 2000 over the past month, it's still trading in a bear market because it hasn't surpassed its all-time high from 2021. The index only needs to gain another 8.9% to get there, and with economic conditions turning in its favor, it could be back in bull territory sooner rather than later.

The Vanguard Russell 2000 ETF (NASDAQ:VTWO) is designed to track the performance of the Russell 2000, so here's why it's a great buy for investors seeking to capture the potential bull run in small caps.

The Vanguard ETF is a great way to add small caps to any portfolio

Eleven different sectors of the U.S. economy are represented in the S&P 500, but the index is dominated by technology, which has a 32.4% weighting. The Russell 2000 is more balanced, with the industrials sector making up 19% of the index, followed by healthcare at 15.2%, and financials at 14.8% (the three largest of its 12 sectors).

The Vanguard ETF aims to closely track the performance of the Russell 2000 by investing in the same stocks and assigning them a similar weighting. As of this writing, the top five holdings in the ETF account for just 1.86% of the total value of its portfolio, so its performance isn't beholden to a handful of stocks.

Data source: Vanguard. Portfolio weightings are accurate as of June 30, 2024, and are subject to change.

Insmed stock is up 136% this year, and it now has a market capitalization of $12 billion, which is a good reference point for the size of the other companies in the Vanguard ETF. Insmed is a biopharmaceutical company that develops therapies for rare diseases, and its Arikayce drug is currently the only approved medication in the U.S. for treating the rare MAC lung disease.

FTAI Aviation stock is up 137% in 2024 at recent prices. It offers maintenance services and produces aftermarket parts for some of the aviation industry's leading aircraft engines. Given the troubles at Boeing lately, fewer new airplanes are being delivered, so some analysts believe FTAI will benefit from increased maintenance requirements for aging fleets.

While investors might not be familiar with many of the stocks in the Russell 2000, there are several quality companies within the index (beyond its top five holdings). Tenable is a leading provider of vulnerability management cybersecurity software, and Axcelis Technologies makes critical equipment for semiconductor manufacturers, including those in the artificial intelligence (AI) space.

Real estate technology company Redfin is also in the Russell 2000, and its stock is absolutely soaring in July as investors weigh the impact of future interest rate cuts on the housing market. Krispy Kreme and dating platform Bumble are two more familiar names in the index.

Image source: Getty Images.

Small caps will benefit from interest rate cuts

According to CME Group's FedWatch tool, the Federal Reserve could cut interest rates three times before the end of 2024. That will reduce the yield on risk-free assets like cash deposits and Treasury bonds, pushing investors into growth assets stocks and real estate instead. That's great news for the overall market, but it's particularly positive for the Russell 2000.

See, the technology giants that dominate the S&P 500 are sitting on hundreds of billions of dollars in cash, so they rarely need to borrow money. Smaller companies, however, often need financing to fuel their growth, and they typically have more floating-rate debt, which is very sensitive to changes in monetary policy. Falling rates will increase their borrowing power, and smaller interest payments could directly boost their earnings.

Plus, the valuation of the Russell 2000 is quite attractive relative to the S&P 500. It trades at a price-to-earnings (P/E) ratio of 16.9 (excluding companies with negative earnings), which is a 28.3% discount to the 23.6 P/E ratio of the S&P 500.

If small caps do get an earnings boost from interest rate cuts and favorable economic conditions, investors might be willing to pay a higher valuation for stocks in the Russell 2000. That will help close the gap.

The Russell 2000 won't outperform the S&P 500 forever

The Russell 2000 could deliver strong returns going forward, but investors who believe it will continue to outperform the S&P 500 should temper their expectations. The Vanguard Russell 2000 ETF has delivered a compound annual return of 9.9% since its inception in 2010, whereas the S&P 500 delivered a substantially higher average annual gain of 13.7% over the same period.

Those 3.8 percentage points every year made a big impact in dollar terms thanks to the effects of compounding:

Calculations by author.

The S&P 500 has a strict criteria for entry, and only the highest-quality companies make the cut. Many of those companies have incredible earnings power -- especially the likes of Nvidia, Apple, and Microsoft -- which no companies in the Russell 2000 can match. Investors will always pay a premium for quality, which is why the P/E ratio of the S&P 500 trades at such a steep premium to the Russell.

With that said, there is a clear case for small caps to generate further gains when interest rates eventually fall, so it isn't a bad idea for investors to add the Vanguard ETF to their portfolio if they don't already have exposure to the Russell 2000.

However, I would caution investors against selling large-cap stocks (especially those in the tech sector) to fund the purchase of small-cap stocks. As I highlighted above, history suggests that is a bad move over the long term.

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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Microsoft, Nvidia, and Redfin. The Motley Fool recommends Bumble, CME Group, and Sprouts Farmers Market and recommends the following options: long January 2026 $395 calls on Microsoft, short August 2024 $11 calls on Redfin, and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.