The major stock-market indexes are at or near their all-time highs, but there are still some areas of the market that look undervalued. Small-cap stocks are one such area. They're trading at their lowest valuations on a price-to-book basis, relative to their large-cap counterparts, in more than 25 years. Value stocks have also been major underperformers.
This isn't too surprising. Indexes like the S&P 500 and Nasdaq Composite are disproportionately reliant on megacap tech stocks, which have performed exceptionally well in recent years. Plus, interest-rate headwinds have put pressure on small caps and value stocks.
However, there's reason to believe that things are about to change. Here are three exchange-traded funds (ETFs) that could be great assets to add to your portfolio right now.
It isn't just a 2024 thing
First, it isn't just that we've seen small-cap and value stocks underperform this year. They certainly have, but it's more of a long-term trend. There are a few reasons for this, such as the incredible relative performance of large-cap tech stocks, which has driven the S&P 500's returns, and pressure from rising interest rates (more on that in a bit), but consider the relative performance:
|
Time Period |
S&P 500 Total Return |
Russell 2000 Total Return |
S&P 500 Value Index |
|---|---|---|---|
|
2024 YTD |
16.3% |
8.6% |
8.9% |
|
1 Year |
22.4% |
11.7% |
15.2% |
|
5 Years |
100.7% |
51% |
78.6% |
|
10 Years |
234.8% |
117.5% |
161.7% |
Data source: YCharts. Performance as of 7/20/2024. YTD = year to date.
Why small caps and value stocks could turn around
We've already seen a bit of an investor rotation into small-cap and value stocks in recent weeks, following inflation data that indicates a Federal Reserve interest-rate cut could be getting close. But this is a relative drop in the bucket, and as you saw in the above chart, the year-to-date gap is still pretty large.
There are a few reasons why small caps and value stocks could outperform as the Fed (hopefully) starts to lower interest rates. Just to name some of the big ones:
- There's a lot of investor money on the sidelines right now, sitting in Treasury securities, high-yield savings accounts, and certificates of deposit (CDs). As rates fall, these will become less attractive, relative to the stock market -- especially when it comes to dividend stocks, which disproportionately fall into the value-stock category.
- Small-cap and value stocks tend to use leverage (borrowed money) in their businesses to a greater extent than their large-cap and growth counterparts. Lower interest rates mean lower borrowing costs.
- When benchmark interest rates fall, it tends to cause yields from dividend-paying stocks to fall, as well. Since yield and share prices have an inverse relationship, falling rates tend to put upward pressure on stock prices.
3 ETFs that could be big winners
I don't think you need to do anything extraordinary to earn great returns here. In fact, my three favorite ways to invest in small caps and value stocks right now are low-cost Vanguard index funds:
- Vanguard Value Index Fund (VTV -0.59%): This fund has a rock-bottom 0.04% expense ratio and invests in a portfolio of about 340 (mostly large-cap) value stocks. Its top holdings include Broadcom, Berkshire Hathaway, and JPMorgan Chase, just to name a few examples.
- Vanguard Real Estate ETFs (VNQ -1.00%): Real estate has been one of the worst-performing parts of the value stock universe in recent years, as this group is exceptionally sensitive to interest-rate increases. This ETF invests in a broad index of real estate investment trusts, or REITs, and has a low 0.13% expense ratio.
- Vanguard Russell 2000 ETF (VTWO -1.48%): The Russell 2000 is an index of 2,000 small-cap companies and could be the best way to get broad exposure to this area of the market. No single company makes up more than 0.41% of the fund, which has a low 0.10% expense ratio.
Invest for the long term
I have absolutely no idea what these ETFs will do over the coming weeks or months. While they should get a nice boost as interest rates gradually normalize, there's no guarantee when that will actually happen.
It's also important to note that I love all three of these as long-term investments. While there's no way to know exactly how this situation will play out, consider that the last time small caps were this undervalued relative to large caps, they outperformed for more than a decade after. The point is that while this looks like a great entry point, these three ETFs could be fantastic long-term investments for those who buy shares now.
