One Vanguard Index Fund to Buy That May Beat the S&P 500 by 100% in the Next Few Years, According to a Wall Street Analyst

Last November, Fundstrat analyst Tom Lee told CNBC that small-cap stocks are headed for a prolonged period of outperformance compared to the large-cap S&P 500 (SNPINDEX:$SPX). "I think small caps could, in the next couple of years, outperform by more than 100%," Lee said.

The opposite has actually happened since he made that prediction. The Russell 2000, a benchmark for small-cap stocks, has tumbled 16%, while the S&P 500 has declined only 8%. However, the investment thesis Lee outlined late last year remains compelling.

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Here's what investors should know.

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The bull case for small-cap stocks in the current market environment

The small-cap Russell 2000 achieved a total return of 7% in the last three years, dramatically underperforming the 40% return in the large-cap S&P 500. But Tom Lee thinks that trend could reverse in the years ahead as small-cap stocks benefit from lower interest rates and more attractive valuations.

The Federal Reserve began lowering its benchmark interest rate in September. That should asymmetrically benefit small-cap companies because they have more floating-rate debt. Indeed, the Russell 2000 returned an average of 45% during the 12-month period following the last five rate-cut cycles, while the S&P 500 returned an average 33%, according to Goldman Sachs.

The Russell 2000 trades at 16 times earnings, and earnings are forecast to grow at 11.5% annually in the next few years, according to Morningstar. Those figures give a price/earnings-to-growth ratio (PEG) of 1.4. Meanwhile, the S&P 500 trades at 22 times earnings, and earnings are forecast to grow at 9.4% annually in the next few years. Those numbers give a less attractive PEG of 2.3.

Lastly, Russell 2000 companies derive one-fifth of sales from outside the U.S., while S&P 500 companies derive one-half of sales from outside the U.S. Because small-cap companies are less dependent on international revenue, they are less sensitive to retaliatory tariffs that may be levied on U.S. exports. It also means they are less sensitive to a stronger U.S. dollar, which may be a consequence of the U.S. imposing tariffs on imported goods.

The Vanguard Russell 2000 ETF provides exposure to small-cap stocks

The Russell 2000 tracks about 2,000 small-cap companies that cover about 5% of U.S. stocks by market value.

The index includes companies from all 11 market sectors, but it leans most heavily toward the industrial (19%), financial (19%), and healthcare (17%) sectors. Comparatively, the S&P 500 is weighted heavily toward the information technology (31%), financial (14%), and consumer discretionary (11%) sectors.

The Vanguard Russell 2000 ETF (NASDAQ:VTWO) provides investors with exposure to the Russell 2000. The five largest holdings in the index fund are listed by weight below:

1. Sprouts Farmers Market: 0.6%
2. Insmed: 0.5%
3. Vaxcyte: 0.4%
4. SouthState: 0.4%
5. FTAI Aviation: 0.4%

The Vanguard Russell 2000 ETF has an expense ratio of 0.07%, which means shareholders will pay $0.70 annually on every $1,000 invested in the fund. The expense ratio on similar funds is 0.98%, according to Vanguard.

Here's the bottom line: Recent interest rate cuts, relatively cheap valuations, and the trade war initiated by the Trump administration could lead to small-cap outperformance in the years ahead. The Vanguard Russell 2000 ETF is a sensible way for investors to position their portfolios for that possible outcome.

However, investors should bear in mind that large-cap stocks have crushed small-cap stocks in recent history. So, I would personally keep my position in the Vanguard Russell 2000 ETF relatively small. And I certainly would not abandon any high-conviction large-cap stocks, nor would I abandon my S&P 500 index fund.

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Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Goldman Sachs Group. The Motley Fool recommends Sprouts Farmers Market. The Motley Fool has a disclosure policy.