Before you buy Vanguard’s S&P 500 ETF, there are three I would buy first

By | March 17, 2024

The Vanguard S&P 500 ETF (NYSEMKT: VOO) is a top choice for most index fund investors. Even Warren Buffett recommends it over any other investment.

There’s a good reason for that. Its low expense ratio and tight index tracking make it a top choice for anyone looking to match the returns of the stock market S&P500. Last year, the exchange-traded fund achieved a total return of 26.3%. But more than half of those returns came from just seven stocks, the ‘Magnificent Seven’.

That left much of the market undervalued, and could represent an opportunity for investors looking beyond the largest companies in the index. These three ETFs offer something beyond the increasingly concentrated S&P 500 and could deliver strong returns in the future.

1. The S&P 500 remixed

When you buy a standard S&P 500 index fund, you get exposure to every company in the index. However, the index is market capitalization weighted. This means that the largest companies in the index, such as the Magnificent Seven, have a greater effect on returns than companies 499 and 500.

An equal-weight S&P 500 index fund, such as the Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP) solves that problem. The fund invests an equal amount in all components of the S&P 500. It is rebalanced quarterly.

By investing equally in all stocks, the weight of the Magnificent Seven is reduced to about 1.4%, compared to more than 28% in the Vanguard S&P 500 ETF. This highlights the performance of the other 493 shares in the index.

While the Magnificent Seven may continue to outperform, the equal-weight index offers investors more diversification. Despite the ETF’s massive underperformance over the past year, investors can expect a reversion to the mean. Since inception, the Invesco fund has slightly outperformed the S&P 500.

2. Think small

Given the dominance of large-cap stocks in recent years, investors may want to pay some attention to small-cap stocks. Small caps have fallen out of favor, especially as interest rates have risen.

Higher interest rates have an outsized effect on smaller businesses for two reasons. First, smaller companies rely more on debt for growth than larger, more profitable companies. As the cost of debt rises, this represents a significant drag on profits. Second, the market must discount future profits of smaller companies at a rate higher than the ‘risk-free rate’ earned by government bonds. As interest rates rise, the discount rate also rises. As a result, the share price falls.

But the Fed is starting to loosen the reins on the economy. Interest rates should fall in 2024 and remain lower in 2025 and beyond. Moreover, the Fed may have managed to avoid a recession, which would be far more damaging to small caps than to larger, more profitable companies.

As such, investors may want to purchase a small-cap index fund ETF. A S&P600 ETF such as the SPDR S&P 600 Small Cap ETF (NYSEMKT: SPSM) includes some of the smallest companies on the market. However, the index requires those companies to show positive earnings in the most recent quarter and four-quarter period. That provides some downside protection, as profitable companies tend to be more stable than unprofitable companies.

3. Search for undervalued small caps

Small-cap stocks may be undervalued as a group, but you may be able to do better by analyzing and selecting stocks that currently seem particularly undervalued by the market.

The Avantis American Small Cap Value ETF (NYSEMKT: AVUV) offers investors a fund full of small-cap stocks trading at attractive value and strong profitability characteristics. The fund managers select shares from the Russell 2000 index with the aim of outperforming the benchmark.

Actively managed funds are not suitable for everyone. There is certainly a risk of underperformance, and the vast majority of actively managed funds underperform their benchmark indices when you take their management fees into account.

However, Avantis charges an expense ratio of only 0.25%, making it relatively cheap. Additionally, small-cap stocks are much less efficiently priced than the big-name large-cap stocks in the S&P 500. That means there’s an opportunity for investors to outperform the market. Avantis has a strong track record in this area since the inception of its small-cap value fund.

Before you buy more shares of the Vanguard S&P 500 ETF, consider one of the ETFs above. They all look very attractive right now in a highly concentrated market.

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

Before you buy Vanguard’s S&P 500 ETF, here are three I’d buy first, originally published by The Motley Fool

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