Market Correction: This Affordable ETF Is Down by Almost 20%

The S&P 500 index has recently entered what is known as market correction territory, defined by a drop of 10% from its peak levels. Yet, other sectors within the stock market have experienced even steeper declines.

One significant area of underperformance during this latest market dip is in small-cap stocks. The Russell 2000 small-cap index has fallen by over 18% from its peak at the end of 2024. This downturn can be attributed to a variety of factors, including rising recession fears, which tend to impact smaller companies more severely.

Despite this recent turmoil, small-cap stocks appeared promising for long-term investors at the start of the year, and they seem even more appealing now. This is why the Vanguard Russell 2000 ETF (VTWO 2.44%) is currently a top contender for my buy list.

What is the Vanguard Russell 2000 ETF?

As indicated by its name, the Vanguard Russell 2000 ETF is an index fund designed to track the performance of the Russell 2000 index, which is often considered the best measure of small-cap stocks.

The median market capitalization of companies in the Russell 2000 is approximately $3.3 billion. While this index is weighted, no single stock constitutes more than 0.6% of the fund. This contrasts sharply with the S&P 500, which is dominated by mega-cap companies. The top holdings in this fund include Sprouts Farmers Market, Insmed, and Vaxcyte. If you are not very familiar with these names, that's intentional—this broad small-cap ETF grants you exposure to numerous smaller companies without requiring extensive individual research.

Similar to other Vanguard funds, this ETF is characterized by low costs, featuring an expense ratio of just 0.07%. In practical terms, this means that for every $10,000 you invest, your annual investment cost amounts to only $7. This cost is not a fee you pay out of pocket; rather, it gets reflected in the fund's overall performance over time.

A wide valuation gap

The Vanguard Russell 2000 ETF was already undervalued a year ago, and it has only become cheaper since then. Early in 2024, small-cap stocks were trading at their lowest price-to-book valuations compared to larger stocks since the late 1990s. However, the rise of mega-cap tech stocks driven by artificial intelligence (AI) innovations caused this valuation gap to widen. Notably, even as the S&P 500 entered correction territory this year, the Russell 2000 index has performed worse.

This situation has led to a significant valuation disparity between small- and large-cap stocks. To illustrate the differences, here are some important metrics:

Metric	S&P 500 Median	Russell 2000 Median
P/E ratio	27.5	17.8
P/B ratio	5.0	2.0
Earnings growth rate	18.9%	14.3%

These figures reflect Vanguard's latest data from the end of January. The valuation gaps have expanded even further since then during the current market correction. Additionally, it's important to note that while the average S&P 500 stock is experiencing faster earnings growth, it does not sufficiently justify such a large valuation spread.

I do not expect the gap to completely close. The S&P 500 holds a substantial proportion of high-growth tech stocks that naturally deserve a premium. However, the current valuation gap between these indexes is the widest in a significant amount of time, and it's feasible that small-cap stocks might eventually catch up.

Small-cap stocks could be big winners in a rebound

For one, small-cap stocks have been disproportionately affected by fears of recession, tariff uncertainties, and disappointing economic indicators. Conversely, a reversal of these issues could yield positive outcomes for small caps.

Furthermore, expectations for interest rate cuts by the Federal Reserve have risen sharply over the past few weeks. The median prediction now suggests three or four quarter-point cuts this year, up from merely one at the year's outset.

If interest rates decrease, small caps stand to benefit significantly. As a group, smaller companies more heavily rely on borrowed capital, and lower interest rates could benefit them greatly. Moreover, as rates decline, investment could shift away from safer assets like Treasury securities and CDs towards the stock market, which would be advantageous for more "risky" investments such as small caps.

Finally, there is potential for tax cuts and regulatory reforms put forth by the current administration. Once the uncertainty surrounding tariffs dissipates, these measures could serve as a considerable boost for smaller companies.

To be clear, the timeline for market turbulence and potential corrections remains uncertain. If economic conditions worsen or tariff concerns escalate further, things could deteriorate before they get better. However, from a long-term viewpoint, the Russell 2000 ETF presents a compelling opportunity right now. Those long-term investors who seize this chance may find themselves rewarded in the future.

Matt Frankel has positions in the Vanguard Russell 2000 ETF. The Motley Fool recommends Sprouts Farmers Market. The Motley Fool has a disclosure policy.

Market, Stocks, ETF