Bet on These 3 Small-Cap ETFs to Ride the January Effect

Wall Street had a wobbly start to 2026, with major stock indices ending the year’s first trading day with a mixed note. While the S&P 500 inched up 0.2% and the Dow Jones Industrial Average gained 0.7%, tech-heavy Nasdaq slipped 0.3%. On a brighter note, the small-cap Russell 2000 index jumped a solid 1.1%, significantly outpacing its large-cap peers.

This early-year strength in small caps might attract investors to watch for the potential return of the "January Effect"—a historical market pattern where stock prices, particularly those of smaller companies, tend to rise more in January than in other months. The phenomenon is often attributed to year-end tax-loss selling, where investors sell underperforming stocks to claim capital losses, potentially depressing prices in December, followed by reinvestment in January. 

This seasonal pattern, combined with several macroeconomic tailwinds, naturally puts the spotlight on small-cap stocks and, by extension, the exchange-traded funds (ETFs) that track them as we begin 2026.

Catalysts Fueling a Potential 2026 Small-Cap Rally

Several converging factors suggest that small-cap stocks could be poised for sustained strength in 2026, extending beyond the January seasonal pattern.

•    Favorable Macroeconomic Outlook: Easing interest rate cycles are expected to boost the performance of small-cap stocks. To this end, Goldman Sachs mentioned in its 2026 Investment Outlook that small-cap companies globally offer compelling opportunities driven by anticipated rate cuts and accelerating earnings. 

•    Attractive Relative Valuations: After more than a decade of underperforming large-cap stocks, small caps are trading at historically cheap levels relative to their larger peers, creating a compelling entry point for investors. As per a November 2025 report by Goldman Sachs, U.S. small caps were trading at a 26% discount to large caps (excluding unprofitable firms), near historic lows. On the other hand, international small caps, which typically trade at a premium, were trading at an 8% discount to international large caps despite offering higher forward earnings growth. 

•    Domestic Economic Advantages: Small-cap companies derive a much larger percentage of their revenues from domestic sources. This positions them to disproportionately benefit from ongoing trends like reshoring and infrastructure build-out, which are less advantageous for large multinationals.

•    AI as a Second-Order Beneficiary: While large tech firms lead in building AI infrastructure, small caps could be disproportionate beneficiaries of AI-driven productivity gains. Since small companies start with lower average operating margins, identical efficiency improvements from AI can lead to significantly larger percentage earnings growth than in large caps.

•    Increased Market Activity: Analysts expect a pick-up in mergers and acquisitions (M&A) and a recovering IPO market in 2026. This activity can create "large idiosyncratic returns" and validate valuations within the small-cap universe.

Why ETFs Over Individual Stocks?

Considering the aforementioned discussion, prudent investors may prefer gaining exposure through a small-cap ETF than picking individual stocks. The small-cap universe contains more than 2,000 companies and is characterized by higher volatility, less public information, and wider dispersion of returns between winners and losers. 

An ETF provides instant diversification across hundreds of these companies, mitigating the substantial risk that any single small company will fail. It also offers a cost-effective, liquid way to capture the overall growth potential of the segment without requiring deep, company-specific research.

3 Small-Cap ETFs to Buy

By adding the following Small-Cap ETFs, investors can capture the broad "January Effect" momentum while mitigating the risk of a single company’s earnings miss or bankruptcy.

Vanguard Russell 2000 ETF VTWO

This fund offers exposure to 1,989 U.S. small-cap stocks, with none accounting for more than 0.9% of the assets. Its top three holdings are Credo Technology CRDO (0.89%), Bloom Energy BE (0.79%) and Fabrinet FN (0.56%). Healthcare, Industrials, Financials, Technology and Consumer Discretionary are the top five sectors with double-digit exposure each. 

VTWO has risen 12.2% over the past year and trades in an average daily volume of 2.17 million shares. The product holds net assets worth $13.7 billion and charges 7 basis points (bps) in annual fees. The fund holds a Zacks ETF Rank #2 (Buy). 

iShares Russell 2000 ETF IWM

This fund offers exposure to 1,959 small public U.S. companies, with none accounting for more than 0.7% of the assets. Its top three holdings are CRDO (0.75%), BE (0.73%) and FN (0.59%). Healthcare, Industrials, Financials, Information Technology and Consumer Discretionary are the top four sectors with double-digit exposure each. 

IWM has gained 12% over the past year and trades in an average daily volume of 35.56 million shares. The product holds net assets worth $74.42 billion and charges 19 bps in annual fees. The fund holds a Zacks ETF Rank #2. 

Vanguard Small-Cap ETF VB

This fund offers exposure to 1,331 small-cap companies in the U.S. equity market, with none accounting for more than 0.6% of the assets. Its top three holdings are Insmed INSM (0.62%), Comfort Systems FIX (0.49%) and Sofi Technologies SOFI (0.48%). Industrials, Financials, Consumer Discretionary, Technology and Healthcare are the top five sectors with double-digit exposure each. 

VB has risen 8.8% over the past year and trades in an average daily volume of 0.73 million shares. The product holds net assets worth $68.9 billion and charges 5 bps in annual fees. The fund holds a Zacks ETF Rank #2. 

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