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

Fundstrat analyst Tom Lee in November told CNBC that small-cap stocks are positioned to crush the S&P 500 (SNPINDEX: ^GSPC) due to relatively cheap valuations and interest rate cuts. "I think small caps, in the next couple of years, could outperform by more than 100%," he predicted.

History supports the notion that small-cap stocks are headed for a period of outperformance. The small-cap Russell 2000 returned an average of 45% during the 12-month period following the last five rate-cut cycles. Meanwhile, the S&P 500 gained an average of 33%, according to Goldman Sachs.

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The Federal Reserve started lowering interest rates in September, but policymakers left rates unchanged in January. That does not necessarily mean the cutting cycle is over, but the downward trend is still good news for the small-cap Russell 2000. Investors can capitalize on its potential outperformance by owning shares of the Vanguard Russell 2000 ETF (NASDAQ: VTWO).

Here are the important details.

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

The Russell 2000 tracks approximately 2,000 small-cap companies that cover 5% of U.S. stocks by market value. The index includes companies from all 11 market sectors, but leans most heavily toward industrials (19%), financials (18%), and healthcare (16%). That differs from the S&P 500 which is most heavily weighted toward the technology sector.

The Vanguard Russell 2000 ETF provides exposure to the Russell 2000. The five largest holdings in the index fund are listed by weight below:

1. FTAI Aviation: 0.5%
2. Sprouts Farmers Market: 0.4%
3. Insmed: 0.4%
4. Vaxcyte: 0.3%
5. Credo Technology Group: 0.3%

Importantly, the Vanguard Russell 2000 ETF has an expense ratio of 0.1%, which means shareholders will pay $1 annually on every $1,000 invested in the fund.

Interest rate cuts and tariffs could be tailwinds for Russell 2000 companies

Small-cap stocks have underperformed large-cap stocks in recent years. The Russell 2000 returned 123% over the last decade, but the S&P 500 gained 258% during the same period. One reason for that underperformance is that small-cap companies can graduate from the Russell 2000. In other words, the better a small-cap stock performs, the more likely it is to outgrow the limits of the Russell 2000 and be added to the S&P 500.

Another reason the Russell 2000 underperformed during the last decade is its limited exposure to technology stocks. The technology sector absolutely crushed the other stock market sectors over the last 10 years, more than doubling the return of the next closest contender, which was consumer discretionary sector.

However, two tailwinds could help the Russell 2000 outperform the S&P 500 in the coming years. First, small-cap companies typically have more floating-rate debt, which means they benefit from interest rate cuts to a greater degree than large-cap companies. That explains why the Russell 2000 beat the S&P 500 by an average of 12 percentage points during the 12-month period following the last five rate-cutting cycles.

Also, small-cap companies have a little less exposure to international markets. Russell 2000 companies derive 21% of revenue from outside the U.S., while S&P 500 companies derive 28% of revenue from outside the U.S. That matters because President Trump has proposed stiff tariffs, and tariffs tend to strengthen the U.S. dollar, creating a currency exchange headwind for companies that operate in international markets.

Investors should consider a small position in the Vanguard Russell 2000 ETF

Here is the bottom line: The Vanguard Russell 2000 ETF provides investors with cheap and easy exposure to small-cap stocks, a market segment that could outperform as lower interest rates and tariffs ripple through the economy. But the S&P 500 performed better over the last decade, and I would not be surprised to see the same outcome in the next decade.

Additionally, while Tom Lee has made several prescient calls in the past, I doubt the Russell 2000 will more than double the return of the S&P 500 in the coming years. So, while owning the Vanguard Russell 2000 ETF is a good portfolio diversification strategy, I think investors should keep their positions relatively small.

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 has a disclosure policy.