Tom Lee believes rate cuts and cheap valuations could drive the small-cap Russell 2000 much higher in the coming months.

Artificial intelligence has been the dominant investing theme for the last two years, and Nvidia has stolen the spotlight. The company reported triple-digit sales growth in the last five quarters, and shares have surged more than sevenfold since January 2023, making it the best-performing stock in the S&P 500 (^GSPC -1.73%) during that period.

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

Importantly, Ken Griffin and David Shaw run the best-performing hedge funds as measured by net gains since inception. Neither fund manager closed their position in Nvidia, so we can't assume they have lost confidence in the chipmaker. But we can assume they are bullish about small-cap stocks.

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

Here's what investors should know.

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

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

Regarding valuations, J.P. Morgan strategist Michael Cembalest recently wrote, "Small-cap stocks are at their cheapest levels in the 21st century with potential market and political catalysts in their favor." But he also noted that small-cap companies are likelier to have lower margins and negative earnings than large-cap companies.

With respect to interest rates, small-cap companies rely more heavily on floating-rate debt, meaning debt with a variable interest rate tied to some 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, and so lower rates are very helpful," according to Sonu Varghese at Carson Group.

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

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

The small-cap Russell 2000 has consistently underperformed the S&P 500 over the last five years, 10 years, and 20 years, and the underperformance was often extreme. For instance, the Russell 2000 returned 105% during the last decade, compounding at 7.4% annually. Meanwhile, the S&P 500 returned 224%, compounding at 12.4% annually.

The iShares Russell 2000 ETF has a reasonable expense ratio of 0.19%, meaning the annual fees will total $1.90 for every $1,000 invested in the fund. For comparison, the average expense ratio across U.S. 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 soar 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 year-end. Additionally, investors who own the iShares Russell 2000 ETF should consider balancing their portfolios with an S&P 500 index fund. The Russell 2000 could conceivably outperform the S&P 500 in the future, but history says that outcome is unlikely to persist over long periods.