This Unstoppable Vanguard ETF Is Obliterating the S&P 500 in 2026, but a Looming Change in Interest Rates Could Halt Its Momentum

The S&P 500 (SNPINDEX: ^GSPC) comprises 500 of America's largest companies, many of which derive a significant portion of their revenue from overseas. The index is up 9.8% this year, but the journey has been extremely volatile because of the ongoing war between the U.S. and Iran, which has roiled global energy markets.

But the Russell 2000 index, which tracks approximately 2,000 of the smallest companies listed on U.S. stock exchanges, has produced a much better year-to-date gain of almost 18%. Many of these companies generate the majority of their revenue inside the U.S., so they are less exposed to geopolitical risks than the multinational giants in the S&P 500.

The Vanguard Russell 2000 ETF (NASDAQ: VTWO) is an exchange-traded fund (ETF) that tracks the Russell 2000. While it's having a great year, a looming rate hike could derail its momentum.

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Small-cap stocks have the wind at their back

The companies in the Russell 2000 are spread across 11 sectors, making the index highly diversified. Plus, while the information technology sector accounts for over one-third of the S&P 500's value, the Russell is much more balanced. The industrial sector has the highest weighting in the index at 19%, followed by healthcare at 17.7% and financials at 16.6%.

Additionally, the top 10 holdings in the Vanguard Russell 2000 ETF account for just 6.7% of the ETF's portfolio, so its performance isn't beholden to a small handful of stocks.

Data source: Vanguard. Portfolio weightings are accurate as of April 30, 2026, and are subject to change.

Those companies might be lesser known than the giants that occupy the top 10 of the S&P 500, but they can still pack a punch. Bloom Energy stock, for instance, has exploded higher by 1,400% over the last 12 months alone. The company is experiencing significant demand for its clean energy solutions from data center operators seeking alternative energy sources to power their artificial intelligence (AI) infrastructure.

Nextpower and Advanced Energy Industries are also experiencing blistering demand for their energy solutions from the AI industry, which is driving strong returns in their respective stock prices.

Fabrinet, Credo Technologies, and TTM Technologies are tackling the AI opportunity from a different angle. They supply semiconductors and components for data centers that address complex networking and connectivity challenges.

Many Russell 2000 companies are somewhat shielded from geopolitical risks because they draw most of their revenue from domestic customers. However, they are also benefiting from favorable government policies. The Trump administration has levied sweeping tariffs on imported goods to make American companies more competitive with foreign counterparts, and it has also continued to slash regulations to reduce the cost of doing business.

Interest rate hikes could derail the rally in small caps

While the Vanguard Russell 2000 ETF is comfortably beating the S&P 500 in 2026, there is one significant risk on the horizon. Elevated oil prices are stoking inflation, with the Consumer Price Index (CPI) coming in at an annualized rate of 3.8% in April. That was a three-year high and almost double the Federal Reserve's yearly target of 2%.

As a result, according to CME Group's FedWatch tool, Wall Street is predicting at least one interest rate hike by January 2027. That is bad news for the stock market in general because higher rates could slow the economy and dent corporate earnings, but it's particularly bad news for the Russell 2000.

Based on a report by Goldman Sachs, around 32% of the companies in the Russell 2000 have floating-rate debt, which means interest rate hikes will immediately increase the cost of their outstanding loans. Not only will this directly impact their earnings, but it will also reduce their borrowing capacity, so they can't access as much additional credit to fuel their growth.

By comparison, just 6% of companies in the S&P 500 have floating-rate debt, so the direct impact of interest rate hikes will be far less pronounced on the large-cap index.

With all that in mind, this might be a good time for investors to trim their exposure to the smaller end of the market, particularly if they are already sitting on strong gains.

Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Bloom Energy, CME Group, Goldman Sachs Group, Modine Manufacturing, Nextpower, and Sterling Infrastructure. The Motley Fool has a disclosure policy.