Small-cap stocks have underperformed large caps for well over a decade, and trade at a massive relative valuation discount. However, the falling-interest rate environment could provide a multiyear tailwind to small caps and could lead to major outperformance.
It can be difficult to choose individual small-cap stocks to invest in, but that’s OK. There are some excellent small-cap ETFs that can allow you to get broad exposure to smaller companies or to invest in a certain type of small cap. Here are three in particular that look attractive right now.
A great small-cap ETF for any portfolio
The Russell 2000 is widely considered to be the best indicator of how small-cap stocks are performing, and one great way to invest in it is the Vanguard Russell 2000 ETF (VTWO -0.72%).
As the name suggests, the ETF owns all 2,000 stocks that make up the Russell 2000, and while it is a weighted index, no company makes up more than 0.5% of the total fund assets. Small-cap stocks could be big winners as rates fall, as they tend to benefit from money flowing into the stock market and out of fixed income, and also tend to rely on borrowed money to a greater extent than large-cap counterparts.
As of this writing, the average Russell 2000 component trades for 1.9 times book value, while the average S&P 500 (^GSPC 0.57%) stock has a price-to-book multiple of 4.7. While I don’t necessarily think this gap will disappear completely due to the S&P 500’s concentration in large-cap tech stocks, it could certainly narrow significantly over the next few years.
Value stocks could shine as rates fall
Not only have large caps outperformed small caps in recent years, but growth stocks have significantly outperformed value stocks as well. The Vanguard Small-Cap Value ETF (VBR -0.52%) is concentrated in sectors that are likely to benefit under the incoming presidential administration’s policies, such as financials and industrials. The ETF has lots of stocks that could benefit from looser regulation, lower corporate taxes, infrastructure spending, and more.
Like most Vanguard funds, this ETF has a rock-bottom 0.07% expense ratio, so investors can keep more of their profits. This is one way to play both the interest rate tailwind and potentially benefit from a more business-friendly environment in the next several years.
A more narrowly focused small-cap ETF
By far the most concentrated small-cap ETF on this list, the Pacer U.S. Small Cap Cash Cows 100 ETF (CALF -1.26%) invests in 100 small-cap companies that have exceptional free cash flow. The average stock owned by the ETF has a 10.39% free cash flow yield, compared with 3.62% for the average stock in the S&P SmallCap 600 Value index.
As a more concentrated ETF, it is more heavily weighted toward top positions. The fund’s top 10 holdings make up 22% of total assets. Plus, its expense ratio of 0.59% is significantly higher than the two Vanguard funds (although it is in line with other highly specialized ETFs).
However, the performance indicates that it might be well worth the cost. Over the past five years, the ETF has produced 15.1% annualized returns, compared with 10.2% for the S&P SmallCap 600.
Which is best for you?
To be sure, all of these ETFs could be big winners in the falling-interest rate environment that is expected to persist for at least the next few years, as well as under a more pro-business political climate. The best choice for you depends on your risk tolerance and goals, but all three of these can be excellent ways to get small-cap exposure right now.
Matt Frankel has positions in Vanguard Russell 2000 ETF and Vanguard Small-Cap Value ETF. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
