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Small-caps are already outperforming the S&P 500 by 8% in the early stages of 2026.
However, their overall quality is poor and they tend to get volatile at the wrong times.
Investors should be cautious about taking a position in the Vanguard Russell 2000 ETF.
Small-caps have gotten off to a fast start to kick off 2026. The Russell 2000 index is already beating the S&P 500 by more than 8% year to date (through Jan. 21), and it's strung together more than a dozen straight trading days outperforming the large-cap index.
The Russell 2000 hasn't beaten the S&P 500 in a full calendar year since 2020. The Vanguard Russell 2000 ETF's (NASDAQ: VTWO) price-to-earnings ratio of 17.5 indicates that there's a fair amount of value waiting to be unlocked in this segment of the market. Is 2026 the year it finally happens?
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The Vanguard Russell 2000 ETF tracks an index of smaller companies whose market caps fall below those of the large-cap Russell 1000 index. These companies are generally considered to have higher growth potential and lower valuations, but are, in many cases, still unprofitable and potentially more speculative than their more established large-cap counterparts.
That's what makes them a unique diversifier, even though they carry the same "U.S. equity" tag. You get better value, the potential for above-average growth with it, and a market composition significantly different from that of the S&P 500.
Is the early part of 2026 a signal that the time for small-caps has finally returned?
One of the big trends we've seen so far this year is the huge rotation out of tech and into other areas of the market. Cyclicals, including industrials, energy, and materials, have been the biggest beneficiaries. Investors no longer seem willing to pay a premium valuation for growth, but they still want stocks that benefit from economic growth.
Small-caps slide right into that trend. They don't have the growth tilt, and the Vanguard Russell 2000 ETF's top three sector exposures are industrials, healthcare, and financials. Tech is only the 4th largest sector holding, at around 12%. If cyclicals keep doing well here, small-caps should be able to ride the wave.
The one thing that makes investing in the Russell 2000 less attractive is its lack of quality. Roughly 40% of companies in the index are unprofitable. In a market correction or earnings downturn, that could hurt small-cap performance. Investors are willing to take the swing on unprofitable companies when economic conditions look good. If conditions turn south, the negative earnings are going to be a real black mark.
Overall, the significant slowing in the labor market is a real cause for concern. But the high-level economic numbers still look pretty good. If that trend can be maintained, small-caps and the Vanguard Russell 2000 ETF continue to look attractive here. Just keep an eye on where the trend is heading. If it turns, it might be time to rethink small-caps.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
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