Large-cap stocks, particularly mega-cap technology companies, have dominated market returns since the Federal Reserve began its aggressive rate-hiking campaign. From March 2022 through Nov. 2024, the S&P 500 delivered a total return of 38.3%, while the Russell 2000 produced a modest 14.9%.
Two key trends suggest this performance gap may be starting to reverse. First, the two-year rally in mega-cap stocks -- fueled by artificial intelligence (AI) and obesity medications -- has pushed valuations to extraordinary levels. Chipmaker Nvidia now trades at 54 times earnings, while pharmaceutical giant Eli Lilly commands an even steeper multiple of 86.1 times earnings. This valuation disparity creates a compelling opportunity in the small-cap landscape, where numerous companies trade below 20 times earnings.
Second, President-elect Trump's victory has reignited interest in small-cap stocks, with the Russell 2000 outpacing the S&P 500 by 3.23% post-election (as of Dec. 2., 2024). His administration is expected to pursue pro-business policies that historically benefit smaller, domestically focused companies. For investors looking to capitalize on these trends, one low-cost Vanguard exchange-traded fund (ETF) offers a compelling option.
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A cost-effective approach to small-cap investing
The Vanguard Small-Cap Index Fund ETF Shares (VB -6.67%) offers investors a compelling way to capitalize on this potential market rotation. The fund provides exposure to 1,383 small-cap companies at a remarkably low expense ratio of 0.05%. Its 30-day SEC yield of 1.35% complements its potential for capital appreciation.
The fund's weighted average price-to-earnings ratio (P/E) of 19.2 represents a significant discount to the S&P 500's 26.9 multiple. This valuation gap highlights potential opportunities as investors look beyond mega-caps. While the fund's five-year average earnings-growth rate of 14.2% trails the S&P 500's 18.8%, this reflects the earlier-stage nature of small-cap companies, rather than diminished potential for future growth.
Diversification meets efficiency
The Vanguard Small-Cap Index Fund ETF Shares' portfolio construction offers natural protection against single-stock risk. Its largest holding, law enforcement technology provider Axon Enterprise, represents just 0.5% of its assets. Other top holdings include paper and packaging manufacturer Smurfit WestRock plc, premium footwear-maker Deckers Outdoor Corp., government consulting-firm Booz Allen Hamilton Holding Corp., and natural gas distributor Atmos Energy Corp., each accounting for less than 0.45% of the portfolio.
This broad diversification stands in stark contrast to the S&P 500's concentration in mega-caps. The Vanguard S&P 500 ETF allocates over 26% of its portfolio to just five companies: iPhone-maker Apple, AI juggernaut Nvidia, software giant Microsoft, e-commerce leader Amazon, and social media titan Meta Platforms. While this concentration has driven remarkable returns in recent years, it also presents heightened risk for investors. These mega-cap tech stocks trade at premium valuations, and their continued market dominance isn't guaranteed in the years ahead.
A complement to Warren Buffett's wisdom
Warren Buffett's famous portfolio advice from his 2013 shareholder letter recommended a 90% allocation to a low-cost S&P 500 fund such as the Vanguard S&P 500 ETF. Today's market environment suggests merit in thoughtfully adapting this time-tested approach.
Market conditions present two compelling reasons for this adaptation. First, the valuation gap between mega-caps and small-caps has rarely been wider.
Second, Trump's expected pro-business stance, including potential deregulation efforts and infrastructure-spending initiatives, historically favors small-cap companies. During Trump's previous administration, the Russell 2000 produced a total return of 68.7%, benefiting from corporate tax reforms and policies promoting domestic economic growth.
While this trailed the S&P 500's 83.2% total return over the same period, today's starting point features small-caps trading at much more attractive valuations.
The Vanguard Small-Cap Index Fund ETF Shares offers investors an efficient way to increase their exposure to this market segment while maintaining a low-cost, index-based strategy. With the fund's attractive valuation, a potential policy tailwind, and its broad diversification, investors may find this an opportune time to complement their core S&P 500 holdings with this small-cap powerhouse.
