When investors turn their attention to U.S. stock investments, the S&P 500 often takes center stage, representing the largest companies across the nation. While this index captures about 500 large-cap stocks, it effectively sidelines approximately 3,000 smaller companies that lack the scale to be included. Historically, this omission was inconsequential as these smaller entities tended to underperform their larger counterparts. The market sentiment has largely been dominated by mega-cap stocks, especially in technology, notably featuring the so-called “Magnificent Seven” that have propelled major indexes higher. However, the looming horizon of the next decade may unfold differently, particularly given recent trends.
In the past year, the Russell 2000—a popular gauge of small-cap stocks—has been steadily outperforming the S&P 500. This shift in dynamics has brought renewed attention to broader market indices such as the Vanguard Total Stock Market ETF (VTI), which encompasses the entire U.S. equity landscape, including both large-cap and small-cap stocks. The VTI is becoming increasingly appealing compared to the Vanguard S&P 500 ETF (VOO), which offers exposure only to large-cap stocks.
Key insights emerge when comparing the two investment vehicles. VTI comprises around 3,500 stocks, with approximately 25% of its portfolio dedicated to mid-cap and small-cap companies, a feature distinct from the S&P 500, which excludes these smaller firms altogether. Presently, small-cap stocks face challenges, particularly in an economic climate marked by elevated inflation and interest rates. Many of these smaller companies operate at a loss, making them more vulnerable. Yet, even amidst these challenges, the Russell 2000 currently maintains an attractive forward price-to-earnings (P/E) ratio of just 16, suggesting potential value in this sector.
The investment case for small-cap stocks focuses fundamentally on long-term earnings growth. After years of large-caps significantly outperforming small-caps, the earnings trajectory is poised for a turnaround. For instance, the S&P 600 small-cap index has experienced negative year-over-year earnings growth through 2023 and 2024. In contrast, larger indices like the Nasdaq-100 have showcased higher earnings growth rates. However, projections for 2026 indicate that the S&P 600 could deliver impressive year-over-year earnings growth of 29%, outpacing even the robust expectations for the Nasdaq-100.
With small-cap stocks trading at a forward P/E ratio of 16—approximately 25% less than that of the Nasdaq-100—investors might gain access to strong earnings growth at a lower price point, enhancing the case for their inclusion in investment portfolios.
The comparison between VTI and VOO further highlights their differing characteristics. While VTI tracks the entire U.S. stock market, VOO is confined to large-cap stocks. VTI offers a more diverse exposure, approximately 25% of which is dedicated to small and mid-cap stocks, and both ETFs have an identical expense ratio of 0.03%. Historically, their 10-year annualized returns are closely aligned, but with the ongoing potential for small-cap growth, VTI may represent a more advantageous option moving forward.
Moreover, owning both large-cap and small-cap stocks allows investors to harness their distinct reactions to market cycles, enhancing portfolio resilience. With large-caps heavily weighted in technology—around 32% of the S&P 500—small-caps provide a necessary balance, as their largest sectors, including industrials and financials, exhibit different characteristics.
Overall, there is a compelling case to be made for small-cap stocks as a strategic addition to portfolios. As earnings growth begins to accelerate, the prospect of undervalued small-caps might offer significant long-term upside, making it an opportune moment for investors to reconsider their allocation strategies.
