Small-cap stocks are trading for their lowest price-to-book valuation relative to their large-cap counterparts in more than 25 years. The average stock in the S&P 500 trades for 4.7 times book value and more than 27 times earnings, while the average stock in the Russell 2000 small-cap index has a price-to-book multiple of just 2 and a P/E ratio of around 17.
With the Federal Reserve finally beginning a much-anticipated cycle of interest rate cuts, there’s a solid case to be made that small-cap stocks are in a unique position to benefit. Instead of searching for the biggest winners in the small-cap world, here are two excellent low-cost ETFs you can buy and hold for the long term.
Vanguard Russell 2000 ETF
The Russell 2000 is a broad index of small-cap stocks, and the Vanguard Russell 2000 ETF (NASDAQ: VTWO) allows investors to get exposure to it without having to choose individual winners. With a rock-bottom 0.10% expense ratio, it lets you keep most of your gains over time.
As the name suggests, the fund invests in all 2,000 components of the index. While it is a weighted index — meaning that larger companies make up a larger proportion of assets — because of the relatively narrow range of market caps and massive number of stocks, even the largest components make up less than 0.5% of the fund’s assets.
SPDR Portfolio S&P 600 Small Cap ETF
The S&P 600 is the other major small-cap benchmark index, and the SPDR Portfolio S&P 600 Small Cap ETF (NYSEMKT: SPSM) is a smart way to invest in it through an index fund. With an expense ratio of just 0.03%, it is about the cheapest way to get exposure to small caps (or any other type of stock for that matter) in the entire market.
Of course, the biggest difference between the Russell 2000 and the S&P 600 is the number of holdings. The S&P 600 has less than one-third the number of stocks and is therefore a somewhat more concentrated ETF. Even so, the largest holding accounts for just 0.76% of the fund’s assets. However, in most other ways, the indexes have similar portfolios — for example, the median market cap of both funds’ holdings is $3.1 billion.
Why small caps, and why now?
Not only is there a large valuation gap between small-cap and large-cap stocks, but there’s reason to believe that the Fed’s newly started rate-cut cycle could be a disproportionately positive catalyst for small caps. In fact, over the past few months as rate cuts became increasingly more likely, the Russell 2000 outperformed the S&P 500 by more than 6 percentage points.
There are a few reasons why falling rates could be good for small caps. For one thing, small caps as a group tend to be more reliant on borrowed money (as a percentage of their total capitalization) and falling rates make it cheaper to take on debt. There is also the fact that there is a lot of money currently on the sidelines in risk-free instruments like Treasuries and CDs, and as rates come down, the appetite for riskier investments like stocks goes up, and market inflows often favor small caps.
The bottom line is that small-cap stocks could be set to outperform over the next few years, but these ETFs can be great to buy and hold for the long run, and can allow you to benefit from small-cap performance without the need to choose individual stocks.
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Matt Frankel has positions in Vanguard Russell 2000 ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
Small-Cap Stocks Could Have a Great 2025 — Here Are 2 ETFs You Can Buy Right Now was originally published by The Motley Fool
