After years of large-cap leadership, the time for small-caps could be near.
The AI-driven earnings acceleration in this category is finally giving it a fundamental boost.
This actively managed ETF is the best way to play this trend.
U.S. stocks continue to power higher despite concerns about inflation, interest rates, government spending, and the war in Iran. Throughout the past year, soaring corporate earnings fueled by the artificial intelligence (AI) boom have been the support the equity market has needed.
The Russell 2000 had been leading the S&P 500 (SNPINDEX: ^GSPC) throughout the first three quarters of the year, but it started losing momentum around August. Small-caps are now trailing large-caps year to date, largely due to the disproportionate negative impact of high yields on smaller companies.
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Profitable small-caps still look pretty intriguing, and they've got the benefit of cheap valuations to boot. That's why the Avantis U.S. Small Cap Value ETF (NYSEMKT: AVUV) looks really attractive at the moment.
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The biggest reason we've seen small-caps lag throughout the AI boom cycle is that earnings growth has been middling to stagnant. But that's changed.
Current expectations are for small-cap earnings to grow by more than 20% year over year in both the third and fourth quarters of 2026. No longer are small company stocks "cheap for a reason." Today, they're cheap with a strong earnings growth story to back them. In terms of their respective risk/reward profiles, small-caps, in my opinion, are now ahead of large-caps.
The small-cap universe has a profitability problem. Roughly 40% of the Russell 2000 index's components are operating in the red. Those can actually outperform in risk-on conditions, as we saw earlier this year. But over the long term, they need the earnings to back them up.
That's where the Avantis U.S. Small Cap Value ETF comes into play. Its strategy emphasizes undervalued opportunities but focuses on higher-profitability companies. That means investors get value without sacrificing quality.
You need to be especially careful when investing in the small-cap value category. I often say that a lot of the stocks in this group are cheap for a reason. They have struggling fundamentals or a poor outlook, and investors simply don't want to bid up these stocks' prices.
This fund removes a lot of this uncertainty from the equation. It's actively managed so it can remain nimble and responsive to market conditions. Its expense ratio is higher than some of the larger ETFs at 0.25%, but you're still not paying much for that active management.
Small caps will face headwinds whenever interest rates are stubbornly high. Right now, I feel the earnings growth story will outweigh it. The Avantis U.S. Small Cap Value ETF trades at a price-to-earnings (P/E) ratio of just 12 right now, so the risk/reward feels right.
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David Dierking has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.