1 Small-Cap ETF to Buy Hand Over Fist and 1 to Avoid

Key Points

• Small-cap stocks have dramatically underperformed large caps recently.

• There could be some excellent tailwinds for small caps in the coming years.

• Whatever happens, a leveraged ETF is usually a losing strategy to bet on a long-term trend.

• 10 stocks we like better than Vanguard Russell 2000 ETF ›

Throughout most of recent history, small-cap stocks have dramatically underperformed their large-cap counterparts. Over the past 10 years, the Vanguard Russell 2000 ETF (NASDAQ: VTWO) that tracks the popular small-cap index has delivered a 106% total return to investors, compared with 257% from the large-cap Vanguard S&P 500 ETF (NYSEMKT: VOO).

Small-cap stocks have also underperformed over the past five years, the past three years, and pretty much any other multiyear time interval over the past decade. And so far in 2025, the S&P 500 has outperformed the Russell 2000 by more than seven percentage points.

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To be sure, there are some good reasons for this. For one thing, we've had two interest rate increase cycles in the past decade, and the benchmark federal funds rate is 400 basis points higher than it was a decade ago. Generally speaking, rising rates can be a drag on all stocks, but disproportionately affect small caps. Plus, the surge in artificial intelligence investment and the strong performance of mega-ap tech stocks has fueled the S&P 500's outperformance for years.

Having said that, there are good reasons to think now could be a great time to add small-cap exposure to your portfolio. First, although the timing is uncertain, most experts agree that the likely direction of interest rates will be downward over the next few years. Second, there's a massive valuation gap between small-cap and large-cap stocks right now, and small caps are looking rather cheap.

Image source: Getty Images.

1 ETF to invest in small caps now

I've been buying shares of several ETFs in 2025, but the one I've been buying most aggressively is the Vanguard Russell 2000 ETF that I mentioned earlier.

If you aren't familiar, the Russell 2000 is the most widely followed small-cap index and invests in 2,000 different companies. It's a weighted index, but no stock makes up more than 1% of the assets, so it's nicely diversified. And like most Vanguard funds, it's a very cost-effective way to invest, with a low 0.07% expense ratio.

In a nutshell, the Vanguard Russell 2000 ETF is a great way to track the performance of U.S. small-cap stocks over time.

1 ETF to be cautious about

If investing in the Russell 2000 is a good idea, investing in an ETF that delivers three times its performance is even better, right? Well, not exactly.

The Direxion Daily Small Cap Bull 3X Shares ETF (NYSEMKT: TNA) aims to deliver three times the daily returns of the Russell 2000. So if the index rises by 1% tomorrow, this ETF should rise by about 3%.

However, it's important to note that the key word is daily. This ETF is not designed to triple the long-term performance of the Russell 2000. And without turning this into a math lesson, the mathematics of daily leveraged returns aren't favorable for long-term investors. As I mentioned earlier, the Vanguard Russell 2000 ETF has delivered a 106% total return over the past decade. During the same period, the Direxion Daily Small Cap Bull 3X Shares ETF produced a negative 15% total return.

Of course, during a short-term bull run, this ETF could be a good performer. In full disclosure, I bought a small position in it after the initial reciprocal tariff announcement sent small-cap stocks plunging in April, but only to hold for a short period. And although I have both of these ETFs in my portfolio, I have roughly 20 times the amount invested in the unlevered Vanguard Russell 2000 ETF.

The bottom line is that leveraged ETFs can be useful to take advantage of short-term mispricings, but are generally not suitable for long-term investments. To be clear, I believe that there's an excellent opportunity in small caps right now, but a simple, low-cost index fund like the Vanguard Russell 2000 ETF is the best way to capitalize on it for the next several years.

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Matt Frankel has positions in Direxion Shares ETF Trust-Direxion Daily Small Cap Bull 3x Shares, Vanguard Russell 2000 ETF, and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.