Small-Cap Stocks Are Crushing the S&P 500. This ETF Could Be the Smartest Buy of 2026

The Russell 2000 index is up 19.5% year to date, nearly doubling the S&P 500's 10.5% return. It's one of the small-cap index's best first-half performances over the past two decades and is finally being driven by improved fundamentals and earnings growth.

I've been modestly underweight small-cap stocks for a while, but I'm finding reason to rethink that today. The exchange-traded fund (ETF) I'd be targeting here is the Vanguard Small-Cap Value ETF (NYSEMKT: VBR).

The current investment case for small-cap value stocks

Two things have been driving the 2026 rally.

Image source: Getty Images.

Attractive valuations

One of the selling points of small-cap value stocks for years has been their low valuations. Today, this ETF trades at a forward price-to-earnings (P/E) ratio of around 14, about in line with its long-term average. That's much lower than the 22 multiple of the Vanguard S&P 500 ETF.

The part to watch out for, however, is that some value stocks are value stocks for a reason. They have broken business models, low growth, or they're struggling to remain viable. Therefore, investors don't want to pay anything near a premium to own the stock.

The Vanguard Small-Cap Value ETF uses the traditional measures to define value, but it also incorporates earnings per share (EPS) into the selection criteria. That helps to potentially avoid or minimize the impact of companies with poor financial health.

Earnings growth is finally accelerating

Up until this past year, the "P" in the P/E ratio hadn't been growing because the "E" hadn't been growing. Value doesn't do much good if that value can't be unlocked. But now, earnings are starting to accelerate. S&P 600 small-cap earnings are forecast to grow 17% in 2026 and 18% in 2027. With the earnings expanding, the price now has a catalyst to run.

A forward P/E ratio of 14, coupled with a 17% earnings growth rate, is a very favorable trade-off. That, in my opinion, makes the Vanguard Small-Cap Value ETF a strong investment opportunity.

There's also a chance the current rally extends. Small caps have underperformed large caps pretty consistently since the economy emerged from the financial crisis. With artificial intelligence (AI) revolutionizing the economic landscape and providing a financial catalyst for smaller companies, we could finally be entering an environment where that built-up value is unlocked.

I wouldn't advocate for a significant overweight position in small-cap stocks. There's danger in swinging the pendulum too far in the other direction. But a modest tilt toward increasing your small-cap exposure looks like a smart, measured choice for your portfolio.

David Dierking has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.