Key insights
- The article suggests that while small-cap stocks like those in the Vanguard Russell 2000 Index ETF (VTWO) can outperform in lower-rate and growing economies, the current environment presents challenges. Rising oil prices due to geopolitical tensions and recession concerns create headwinds for small-cap performance due to their higher leverage and sensitivity to economic downturns.
Buying small-cap stocks over the past few years has not been a winning proposition. Investors have poured into large-cap tech stocks, especially ones with the greatest expected upside from artificial intelligence, and they've been greatly rewarded for doing so. Even mid-cap stocks have outperformed small-cap stocks over the past five years.
But investors should always remember that the goal is to buy stocks or exchange-traded funds (ETFs) when they're on sale or out of favor, with the idea that they will outperform in the long term. However, it's easier said than done, as stocks and ETFs usually trade at low prices for a reason. The difficulty lies in separating the value investments from the value traps.
Which category is the Vanguard Russell 2000 Index ETF (VTWO 1.68%) in? Should you buy it now?
Small-cap stocks tend to have higher growth trajectories than mature, large-cap stocks, but they're also more volatile and more highly leveraged. That's why small-cap stocks and, therefore, the Russell 2000 index, tend to perform better in a lower-interest-rate environment. If they have adjustable-rate debt, the interest rate on that debt can reprice lower, reducing interest expense. This has broad, positive implications for a company's financials.
Furthermore, small-cap stocks tend to perform better when the economy is growing, and people and businesses can spend and invest. This also often occurs when rates are lower.
While rates have fallen in recent months, the current environment is not ideal for small caps. The conflict in Iran has jacked up oil prices, which could hit smaller companies hard, especially if the rise persists. Plus, amid signs of weakness in the labor market, many investors are increasingly concerned about a recession.
Recessions can also be tough environments for small caps because demand weakens, and their balance sheets are typically not as strong as those of larger companies.
Ultimately, it's not the best environment for small-cap stocks, due to concerns about oil prices and a potential recession. That said, if you are a long-term investor with a five-year or longer horizon, I would recommend some exposure to the Russell 2000.
Investors are still too concentrated in large-cap tech. Over 30% of the Russell 2000 is invested in the financials and healthcare sectors, which have underperformed other sectors and remain vital to the economy. Many of these companies could ultimately benefit from AI and currently trade at more reasonable valuations.
So while I'm not necessarily recommending that investors go overweight small-cap stocks, I believe allocating some capital to small caps will work out well in the long term.