Investors should take every prediction from Wall Street analysts with a grain of salt, because they don't always get things right. However, Tom Lee from Fundstrat Global Advisors has made some stellar calls over the last couple of years:

• He predicted the S&P 500 (SNPINDEX: ^GSPC) index would soar to 4,750 in 2023 (while many other analysts were bearish), and it ended the year at 4,769.

• He came into 2024 with a 5,200 target for the index, which was hit within three months.

• Lee then forecasted the S&P 500 would hit 5,500 by the end of June, and it did.

• He followed that up with a year-end call of 5,700, which has already been surpassed.

But Lee also came into 2024 with an ambitious target for another stock market index: The Russell 2000, which features approximately 2,000 of the smallest companies listed on U.S. stock exchanges. He believed the combination of falling interest rates and cheap valuations in small-cap stocks would propel that index to a 50% gain in 2024.

The Russell 2000 is currently up just 10% year to date, so it would have to soar another 37.3% in the next three months to meet Lee's forecast. That seems very unlikely, but the Federal Reserve did slash interest rates in September, and Lee reiterated his bullish stance on the smaller end of the stock market a few days later.

The Vanguard Russell 2000 ETF (NASDAQ: VTWO) directly tracks the performance of the Russell 2000, so it's a simple way for investors to profit if Lee turns out to be right.

The Vanguard ETF is a simple way to invest in small-caps

The technology sector makes up almost one-third of the entire value of the widely followed S&P 500 index, so its performance is heavily influenced by a small number of stocks. The Russell 2000, on the other hand, is far more balanced across its 11 different sectors.

Its largest sector is industrials with a weighting of 18.9%, followed by healthcare at 15.1%, financials at 15%, and consumer discretionary at 12.6%.

In fact, the top 10 holdings in the Vanguard Russell 2000 ETF represent just 3.47% of the total value of its entire portfolio:

Data source: Vanguard. Portfolio weightings are accurate as of Aug. 31, 2024, and are subject to change.

Following a 209% gain in its stock this year, FTAI Aviation has a market capitalization of $14.3 billion, making it the largest company in the Russell 2000. It supplies aftermarket aircraft engine components and provides maintenance services to airlines. It's benefiting from Boeing's regulatory issues because the manufacturer is shipping fewer planes, so airline companies have to run older fleets, which require more maintenance.

Insmed is a biopharmaceutical company that develops therapies for rare diseases. Then there is Sprouts Farmers Market, an organic grocery chain with more than 400 stores across the U.S.

Outside of its top 10 positions, the Vanguard ETF holds well-known names like cybersecurity powerhouse Tenable, semiconductor-service company Axcelis Technologies, and clothing retailer Abercrombie and Fitch.

Interest rates are falling, which is a tailwind for small-caps

The Fed slashed the federal funds rate (overnight interest rates) by 50 basis points at its September policy meeting, because inflation is trending toward its target and there were signs that the jobs market is getting less robust. As a result, the Fed's future projections also suggest more cuts are on the way in 2024, 2025, and even 2026.

Rate cuts tend to benefit smaller companies more than large ones. Tech giants like Apple, Microsoft, and Nvidia are sitting on so much cash that they each return tens of billions of dollars to their shareholders every year through stock buybacks and dividends. They don't need debt financing.

But smaller companies often need to borrow money to fuel their growth. A lot of that debt comes with floating interest rates, which are very sensitive to changes in the Fed's policy rate. Therefore, when interest rates come down, small companies experience an increase in their borrowing capacity and a reduction in their interest payments, both of which can be a tailwind for their earnings.

That's why Tom Lee believes lower rates could push the Russell 2000 higher, especially considering its current valuation. The index trades at a price-to-earnings (P/E) ratio of just 17.8 (excluding companies with negative earnings), which is a 35% discount to the 27.4 P/E ratio of the S&P 500.

Investors pay a premium for the S&P 500 because of the extremely high quality of its constituents. Apple, Microsoft, and Nvidia, for example, have track records of success that span decades, along with secure revenue streams, and consistent earnings growth. Therefore, it's unlikely the Russell 2000 will completely close the valuation gap to the S&P 500, but it could certainly make some inroads if rates continue to fall as expected.

Tom Lee's forecast might be ambitious

A gain of 50% for the Russell 2000 might be out of reach this year, since it's only up 10% so far. But there's another glaring problem: The index has never returned 50% in a single year (going all the way back to 1988).

The Vanguard Russell 2000 ETF has delivered a compound annual return of just 10.4% since it was established in 2010, so a 50% gain would be truly extraordinary. Plus, the federal funds rate was below 1% for most of the period between 2010 and 2022, which still wasn't enough to drive outsized gains in small-caps.

The index could certainly climb further in the final three months of 2024, but a 37.3% gain in that stretch is probably out of the question. With that said, for investors who already have ample exposure to the S&P 500, adding the Vanguard Russell 2000 ETF to their portfolio can be a good way to diversify.

However, investors with no exposure to the S&P 500 might want to look there instead. The Vanguard S&P 500 ETF has delivered a compound annual return of 14.7% since 2010, so it's crushing the Russell 2000 ETF. That 4.3% differential each year makes a huge difference in dollar terms, thanks to the effects of compounding:

Calculations by author.

Given the quality of the companies in the S&P 500, it's likely to continue outperforming the smaller end of the market for the long term.

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Anthony Di Pizio has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Apple, Microsoft, Nvidia, and Vanguard S&P 500 ETF. The Motley Fool recommends Sprouts Farmers Market and recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.

1 Vanguard ETF That Could Soar 37.3% Before the End of 2024, According to a Select Wall Street Analyst was originally published by The Motley Fool