Before You Buy the Vanguard’s S&P 500 ETF, Here Are 3 I’d Buy First

The Vanguard S&P 500 ETF (NYSEMKT: VOO) is a top choice for most index fund investors. Even Warren Buffett recommends it above 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 S&P 500. Last year, the exchange-traded fund produced a total return of 26.3%. But more than half of those returns came from just seven stocks, dubbed the “Magnificent Seven.”

That left a lot of the market underappreciated, and that could mean an opportunity for investors willing to look beyond the biggest companies in the index. These three ETFs offer something that goes beyond the increasingly concentrated S&P 500 and could produce strong returns going forward.

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 cap weighted. That means the biggest companies in the index, like the Magnificent Seven, have a bigger effect on returns than companies 499 and 500.

An equal-weight S&P 500 index fund like the Invesco S&P 500 Equal Weight ETF (NYSEMKT: RSP) solves that issue. The fund invests an equal amount in all constituents of the S&P 500. It rebalances once per quarter.

Investing equally across every stock reduces the weight of the Magnificent Seven to about 1.4%, versus more than 28% in the Vanguard S&P 500 ETF. That allows the performance of the other 493 stocks in the index to shine through.

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

2. Think small

With the dominance of large-cap stocks over the past few years, investors may want to give some attention to small-cap stocks. Small-caps have fallen out of favor, especially as interest rates have climbed.

Higher interest rates have an outsized effect on smaller companies for two reasons. First, smaller companies are more reliant on debt for growth than larger, more profitable companies. As the cost of debt increases, it represents a meaningful drag on earnings. Second, the market must discount future earnings from smaller companies at a rate higher than the “risk free rate” earned from Treasury bonds. As interest rates go up, so does the discount rate. As a result, the stock price goes down.

But the Fed is starting to loosen the reins on the economy. Interest rates should come down in 2024 and continue lower in 2025 and beyond. What’s more, the Fed may have managed to avoid a recession, which would be much more detrimental for small-caps than larger more profitable companies.

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

3. Searching for undervalued small-caps

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

The Avantis US 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 stocks from the Russell 2000 index with the goal of outperforming the benchmark.

Actively managed funds aren’t for everyone. There’s certainly a risk of underperformance, and the vast majority of actively managed funds underperform their benchmark indexes when you account for their management fees.

However, Avantis charges an expense ratio of just 0.25%, making it relatively inexpensive. What’s more, small-cap stocks are much less efficiently priced than the big well-known large-cap stocks found in the S&P 500. That means there’s an opportunity for investors to outperform the market. Avantis has a strong track record of doing just that 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 above ETFs. They all look very attractive right now amid a heavily concentrated market.

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Adam Levy 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.

Before You Buy the Vanguard’s S&P 500 ETF, Here Are 3 I’d Buy First was originally published by The Motley Fool