You might be surprised by what my favorite ETF is right now.
The so-called “Magnificent Seven” have driven a disproportionate amount of the stock market’s returns in recent years, and that’s even true after stocks like Nvidia pulled back recently. Over the past year, the Magnificent Seven are collectively up by 43%, compared to 21% for the S&P 500 as a whole.
However, the market environment over the next few years could favor a different type of stock.
To be perfectly clear, this is intended to be a bold prediction. In the right set of circumstances, the megacap tech stocks could certainly continue to outperform. But while I believe in the long-term potential of things like artificial intelligence (AI), rapidly falling interest rates and improved consumer confidence favor small caps and value stocks. And the Vanguard Small-Cap Value ETF (VBR 1.33%) lets you invest in a portfolio of both in a single investment.
What is the Vanguard Small-Cap Value ETF?
The Vanguard Small-Cap Value ETF, as the name suggests, is an index fund that invests in small-cap stocks that have value characteristics. As of the latest data, the fund has 848 different stocks with a median market cap of 13.5%. It also has a rock-bottom fee structure, with an expense ratio of just 0.07%, which means that if you invest $1,000, just $0.70 will go toward investment expenses on an annual basis.
This is a highly diversified ETF, with no stock making up more than 0.63% of the fund’s holdings. And while you might not be too familiar with most of the stocks it owns (that’s kind of the point of a small-cap ETF), a few of the better-known components include Booz Allen Hamilton (BAH -0.06%), Williams-Sonoma (WSM 2.74%), and BJ’s Wholesale Club (BJ -0.82%).
Why this ETF could deliver excellent returns
Small-cap value stocks are cheap right now. The average price-to-book ratio (P/B) of stocks owned by the Vanguard Small-Cap Value ETF is 1.7, and the average stock trades for just 14.1 times earnings. Compare this to the Vanguard S&P 500 ETF (VOO 1.66%), where the average stock trades for 4.7 times book value and for more than 27 times earnings.
This is a big valuation gap. In fact, the last time the P/B valuations were so different between large and small companies was 25 years ago, and small caps outperformed for more than a decade after.
Having said all that, I’m not simply hoping that the gap narrows over the next few years. There’s good reason to believe there will be catalysts that could make it happen, specifically when it comes to interest rates.
After a wave of cooler-than-expected inflation data and relatively weak employment data, expectations for Federal Reserve interest rate cuts have soared in recent weeks. Now, the mean expectation is for a total of two full percentage points in rate cuts between now and September 2025, with the potential for more to follow.
A falling-rate environment could be good news for small caps and value stocks for a couple of big reasons. First, companies that fall into these categories tend to use leverage (debt) to a greater extent than their large-cap counterparts. Lower interest rates mean lower borrowing costs.
Second, and more importantly, we saw a massive rotation out of small caps and income-focused stocks when rates started rising. And it wasn’t surprising: After all, income stocks like utilities and real estate investment trusts (REITs) become less appealing to income-seeking investors when they can get 5% yields from CDs and short-term Treasury securities.
However, as risk-free interest rates fall, it could cause billions to flow back into these areas of the stock market. Plus, yield and price have an inverse relationship, so as the interest rate environment cools off, it tends to put upward pressure on stocks with reliable dividends (which tend to fall into the “value stock” category).
My bold prediction
I’m not necessarily saying that the Vanguard Small-Cap Value ETF is going to outperform stocks like Nvidia, Alphabet, and Amazon over the long term, but my prediction is that through at least the end of 2025, this ETF will outperform the Magnificent Seven as a whole.
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Matt Frankel has positions in Amazon, Vanguard S&P 500 ETF, and Vanguard Small-Cap Value ETF. The Motley Fool has positions in and recommends Alphabet, Amazon, Nvidia, Vanguard S&P 500 ETF, and Williams-Sonoma. The Motley Fool recommends Booz Allen Hamilton. The Motley Fool has a disclosure policy.
