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Many investors are familiar with the three major U.S. stock market indexes. I am talking about the S&P 500 (SNPINDEX: ^GSPC), the Dow Jones Industrial Average (DJINDICES: ^DJI), and the Nasdaq Composite (NASDAQINDEX: ^IXIC). Those three indexes cover different facets of the domestic stock market, but they all measure the performance of large-cap U.S. companies.

Fewer investors are familiar with the Russell 2000, an index that measures the performance of small-cap U.S. companies. It currently trades at 2,000. But Tom Lee, Head of Research at Fundstrat Global Advisors, believes the small-cap index could soar 50% to surpass 3,000 before the end of 2024. That implies identical upside in the little-known Vanguard Russell 2000 ETF (NASDAQ: VTWO).

Lee sees cheap valuations and interest rate cuts as the catalysts behind those potential gains.

The Vanguard Russell 2000 ETF

The Vanguard Russell 2000 ETF tracks the small-cap Russell 2000, which covers roughly 8% of U.S. equities by market capitalization. Some investors associate the terms small-cap and large-cap with companies of a specific size, but the definitions change over time as the economy expands. The Russell 2000 includes the 2,000 smallest stocks in the Russell 3000, an index that covers about 98% of U.S. equities by market capitalization.

The 10 largest positions in the Vanguard Russell 2000 ETF are listed by weight below.

1. Super Micro Computer: 1.9%
2. MicroStrategy: 0.9%
3. e.l.f. Beauty: 0.4%
4. Comfort Systems: 0.4%
5. Light & Wonder: 0.3%
6. Carvana: 0.3%
7. Onto Innovation: 0.3%
8. Simpson Manufacturing: 0.3%
9. Viking Therapeutics: 0.3%
10. Weatherford International: 0.3%

As mentioned, Tom Lee identified two tailwinds that could drive the Russell 2000 up 50% this year. First, small-cap stocks trade at a relative discount to large-cap stocks. Second, small-cap companies should benefit greatly when the Federal Reserve begins cutting interest rates.

Small-cap stocks look cheap compared to large-cap stocks

The S&P 500 includes about 80% of U.S. stocks by market capitalization, and the large-cap index currently trades at 20 times forward earnings, a premium to the 10-year average of 17.8 times forward earnings. That means many large-cap stocks are historically expensive. For that reason, Tom Lee sees small-cap stocks as a more attractive option, and other Wall Street analysts agree.

For instance, according to JPMorgan Chase, small-cap stocks trade at an 11% premium to their average price-to-earnings ratio over the last two decades, whereas large-cap stocks trade at a 34% premium to their average price-to-earnings ratio during the same period. Likewise, Ed Clissold at Ned Davis Research was quoted by Morningstar in November as saying, "Small caps are trading near their steepest discount on record."

To that point, Tom Lee thinks the valuation gap between small-cap stocks and large-cap stocks is reminiscent of 1999, and that bodes well for the Russell 2000. As shown below, the Russell 2000 returned 236% between 1999 and 2014, more than doubling the performance of the S&P 500.

^RUT data by YCharts. The chart compares returns in the Russell 2000 and the S&P 500 between January 1999 and January 2014. The Russell 2000 more than doubled the performance of the S&P 500 during that 15-year period.

Small-cap stock should benefit greatly from interest rate cuts

Small-cap companies are generally more sensitive to interest rates than large-cap companies because they typically get less favorable terms on fixed-rate loans, and they tend to carry more floating-rate debt, meaning their interest payments depend on prevailing interest rates. Indeed, 38% of Russell 2000 debt is floating rate, but just 7% of S&P 500 debt if floating rate, according to JPMorgan.

The upshot is that small-cap stocks have been hit hard during the last two years because the Federal Reserve has raised its benchmark interest rate to its highest level since 2001. As a result, the Russell 2000 has advanced just 5% since April 2022, but the S&P 500 has returned 22%. But the opposite could happen once the Federal Reserve begins cutting interest rates, and the market currently expects the Federal Reserve to cut rates by at least 25 basis points this year, according to CME Group's FedWatch Tool.

The Vanguard Russell 2000 ETF is worth buying, but investors should temper their expectation

Whether the Vanguard Russell 2000 ETF returns 50% during the remainder of 2024 depends in large part on the macroeconomic environment, especially interest rates. If the U.S. suffers a recession, or if the Federal Reserve lowers rates more slowly than anticipated, the probability of a 50% return would be close to zero.

Conversely, if the U.S. economy remains resilient and policymakers cut interest rates faster than anticipated, the Vanguard Russell 2000 ETF could conceivably return 50% this year. Personally, I find that outcome farfetched given that U.S. GDP growth decelerated much more sharply than expected in the first quarter and inflation has actually gotten worse in recent months.

However, investors should still consider buying a position in the Vanguard Russell 2000 ETF. The index fund is a convenient way to get exposure to small-cap companies at a time when those stocks are primed to outperform. Additionally, the Vanguard Russell 2000 ETF bears a below-average expense ratio of 0.1%, meaning the annual fee on a $10,000 portfolio would be just $10.

To be clear, I would not invest my entire portfolio (or even a quarter of my portfolio) in the Vanguard Russell 2000 ETF. The S&P 500 more than doubled the performance of the Russell 2000 over the last decade, so I would encourage passive investors to prioritize an S&P 500 index fund. But given the current market environment, allocating 5% to 15% of a portfolio to the Vanguard Russell 2000 ETF is a sensible move.

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JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends JPMorgan Chase, Light & Wonder, Simpson Manufacturing, and e.l.f. Beauty. The Motley Fool recommends CME Group. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.