The Russell 2000 index represents approximately 2,000 of the smaller listed stocks in the U.S. Historically, it hasn't performed as well as the S&P 500 because it doesn't have as much exposure to fast-growing technology segments like cloud computing, enterprise software, and artificial intelligence (AI).
However, the Russell 2000 is up 7.4% in July alone, compared to a mere 1.5% gain in the S&P 500. Investors are increasingly bullish on the smaller end of the market because it will likely benefit the most from interest rate cuts, which are forecast to come before the end of the year.
Technically speaking, the Russell 2000 has been in a bear market since 2022. It won't officially enter a new bull market until it makes a new all-time high, but it only has to rise another 10.9% to get there. We've seen how quickly the Russell can make up ground recently, so if economic conditions turn in favor of small caps as expected, it won't take long for the index to move higher.
Buying the iShares Russell 2000 ETF(NYSEMKT: IWM) is a simple way to get exposure to this trend, and here's why investors might want to add it to their portfolio.
The iShares ETF is a great way to invest in small caps
The S&P 500 faces growing concentration risk right now, because the top five stocks in the index account for 26.2% of its value. They each operate in the technology sector, so any hiccup in the enthusiasm for artificial intelligence (AI) stocks could cause the entire index to underperform, much like we've seen so far in July. The Russell 2000 is more balanced, with the largest stock in the index accounting for just 1.77% of its total value.
The iShares exchange-traded fund (ETF) is even less concentrated. It uses a representative sampling strategy, which means its portfolio is constructed to have a similar profile to the Russell 2000 even if its holdings differ slightly. The iShares ETF holds 1,989 small-cap stocks, and here are its top five positions and their weighting:
Stock
iShares ETF Portfolio Weighting
1. Insmed
0.44%
2. FTAI Aviation
0.38%
3. Fabrinet
0.34%
4. Vaxcyte
0.33%
5. Sprouts Farmers Market
0.31%
Data source: iShares. Portfolio weightings are accurate as of July 17, 2024, and are subject to change.
Insmed is a biopharmaceutical company focused on developing treatments for rare diseases. Its Arikayce drug is the only approved medication in the U.S. for treating the rare MAC lung disease. Insmed has a market capitalization of $12.2 billion, which is a good reference point for the size of the other companies in the iShares ETF.
FTAI Aviation offers maintenance services and aftermarket parts for airplane engines, including those manufactured by industry giants like GE Aerospace. Its stock is up a whopping 127% this year alone amid Boeing's production issues because some analysts believe fewer deliveries of new planes could lead to more maintenance requirements for aging fleets.
There are some hidden gems in the iShares ETF outside of its top five. Tenable Holdings is a specialist in the vulnerability management segment of the cybersecurity industry, and Axcelis Technologies is a critical semiconductor company that is about to experience a strong tailwind from the AI boom.
Interest rate cuts could be around the corner
Tech giants like Nvidia and Microsoft are sitting on mountains of cash, so they typically don't need to borrow money. Smaller companies, on the other hand, often rely on debt to fuel their growth, so they are very sensitive to changes in interest rates.
Wall Street generally expects the U.S. Federal Reserve to cut interest rates two times (and a few analysts are betting on three times) before the end of 2024 on the back of cooling inflation data and a recent uptick in the unemployment rate. That's one of the key reasons for the spike in the Russell 2000 over the last few weeks.
Lower rates will allow the small caps to borrow more money, which could drive faster growth, and it will also translate into lower debt-servicing costs, which should directly boost their earnings.
Small caps look cheap relative to their larger peers
The iShares ETF trades at a price-to-earnings (P/E) ratio of just 15.9 (excluding companies with negative earnings). That makes it far cheaper than the S&P 500, which trades at a P/E ratio of 24.3, but the S&P certainly deserves some premium due to the sheer quality of the stocks in the index.
The iShares ETF has delivered a compound annual return of 7.6% since its inception in the year 2000, which is on par with the S&P 500 over the same period. However, its average annual return of 6.9% over the last 10 years significantly lags the 13.2% annual gain in the S&P. The widening gap can be explained by the rapid growth of tech stocks, which is another reason investors are willing to pay a premium for the S&P over the Russell.
With that said, falling interest rates should lead to a more favorable economic environment for small caps. That will drive further momentum in the Russell 2000 and potentially catapult it into a new bull market. Therefore, the iShares ETF could be a valuable addition to a balanced portfolio.
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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Microsoft and Nvidia. The Motley Fool recommends Sprouts Farmers Market and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.
