Billionaires are selling Nvidia shares and buying an index fund that could rise 43%, according to a Wall Street analyst

Artificial intelligence has been the dominant investment theme for the past two years and Nvidia stole the limelight. The company has reported triple-digit sales growth over the past five quarters, and the stock is up more than sevenfold since January 2023, making it the best-performing stock in S&P 500 (^GSPC -1.73%) during that period.

However, artificial intelligence is not the only theme that investors should explore. The hedge fund managers listed below (all of whom are billionaires) sold Nvidia shares in the second quarter while buying shares of the company. iShares Russell 2000 ETF (IWM -1.90%)an index fund that tracks small caps Russell 2000.

• Ken Griffin of Citadel Advisors sold 9.2 million shares of Nvidia, reducing his stake by 79%. He also added 125,383 shares of the iShares Russell 2000 ETF (exchange-traded fund), increasing his position by 27%.
• David Shaw of DE Shaw & Co. sold 12.1 million Nvidia shares, reducing his stake by 52%. He also added 638,084 shares of the iShares Russell 2000 ETF, increasing his position by 169%.

Importantly, Ken Griffin and David Shaw manage the top-performing hedge funds, as measured by net gains since inception. None of the fund managers closed their position in Nvidia, so we cannot assume that they have lost faith in the chip maker. But we can assume they are bullish on small-cap stocks.

Tom Lee, head of research at Fundstrat Global Advisors, shares this optimistic outlook. In January, he told CNBC that the Russell 2000 could end the year above 3,000. That implies a 43% upside from the current level of 2,091, suggesting identical gains for shareholders of the iShares Russell 2000 ETF.

Here’s what investors should know.

The case of small-cap stocks

The Russell 2000 Index measures the performance of about 2,000 small-cap U.S. stocks, representing 5% of domestic stocks in terms of total value. The median market capitalization among Russell 2000 companies is about $1 billion. By comparison, the S&P 500 is a large-cap index, with an average market capitalization of $33 billion.

Tom Lee is bullish on small-cap stocks for two reasons. First, small-cap valuations are at their cheapest level in decades compared to large-cap stocks. Second, small-cap companies are more sensitive to interest rates, so they will benefit more than large-cap companies when the Federal Reserve starts cutting rates.

In terms of ratings, JP Morgan Strategist Michael Cembalest recently wrote, “Small-cap stocks are at their cheapest levels in the 21st century, with potential market and policy catalysts in their favor.” But he also noted that small-cap companies are more likely to have lower margins and negative earnings than large-cap companies.

In terms of interest rates, small-cap companies rely more on floating-rate debt, meaning debt with a variable interest rate tied to a specific benchmark, often the federal funds rate. So when the Federal Reserve lowers its benchmark rate, floating-rate debt becomes less expensive. “Small-cap companies tend to take on more floating-rate debt, so lower rates are a big help,” according to Sonu Varghese of the Carson Group.

Importantly, the market expects the Federal Reserve to begin cutting interest rates at its meeting later this month.

iShares Russell 2000 ETF

The iShares Russell 2000 ETF allows investors to spread capital across the Russell 2000 Index, giving them diversified exposure to approximately 2,000 small-cap companies. The top 10 holdings in the index fund are listed below by weight:

1. Vaxcyte: 0.5%
2. FTAI Aviation: 0.5%
3. Insmed: 0.4%
4. Sprouts Farmers Market: 0.4%
5. Ensign Group: 0.3%
6. Factory: 0.3%
7. Fluorine: 0.3%
8. Therapeutics with halozymes: 0.3%
9. Mueller Industries: 0.3%
10. Applied industrial technologies: 0.3%

The small-cap Russell 2000 has consistently underperformed the S&P 500 over the past five years, 10 years and 20 years, and the underperformance has often been extreme. For example, the Russell 2000 has returned 105% over the past decade, coming in at 7.4% annually. Meanwhile, the S&P 500 returned 224%, yielding 12.4% annually.

The iShares Russell 2000 ETF has a reasonable expense ratio of 0.19%, meaning annual fees will total $1.90 for every $1,000 invested in the fund. By comparison, the average expense ratio for US index funds was 0.36% in 2023, according to Morningstar.

Here’s the bottom line: Patient investors should consider buying a small position in the iShares Russell 2000 ETF today. The index fund could rise when the Federal Reserve starts cutting rates and small-cap stocks trade at historically cheap valuations.

However, shareholders should not expect a 43% return by the end of the year. In addition, investors holding the iShares Russell 2000 ETF should consider rebalancing their portfolios with an S&P 500 index fund. The Russell 2000 may outperform the S&P 500 in the future, but history says that performance is unlikely to persist over long periods of time .