This class of stocks has been largely left behind, and you can buy them all with a simple index fund.
The Vanguard S&P 500 ETF (VOO -0.84%) is one of the most popular investment options for index investors. And with good reason. Its low expense ratio and strong track record of tracking the index make it a great option for those simply looking to match the .
This year, Vanguard S&P 500 ETF shareholders have been treated to a return of around 17%. But those returns were driven by just a handful of megacap stocks held by the fund. Meanwhile, the rest of the market has been roughly flat, and there are some segments that have been severely beaten down.
Before you start buying the Vanguard S&P 500 ETF or adding to your existing position, there are three other ETFs you should consider first. These ETFs track a part of the market that's been beaten down lately but has historically outperformed the S&P 500. And at today's prices, they look more appealing than ever.
Think small to win big
Over the long run, small-cap stocks have outperformed large-cap stocks. And small-cap value stocks have outperformed even more.
After such strong returns from the largest companies in the public market, small-cap value stocks are trading at extremely low valuations. The S&P 600, which tracks profitable small-cap companies, has a P/E ratio of around 11.6. That's a valuation the index has only rarely seen over the past 15 years.
But before you get too excited, there's good reason for the low valuations of small-cap stocks.
For one, small caps are much more susceptible to economic downturns than large caps. It's tough to imagine Apple going out of business during an economic recession. But a lot of small caps could see their stocks go to $0 per share if that were the case. Given the ongoing macroeconomic uncertainty, investors are more wary of small-cap stocks.
On top of that, small caps are far more susceptible to interest rate changes than larger, more established companies with solid balance sheets. They're generally more reliant on debt for growth, which means as borrowing costs climb they can have a significant impact on operating costs. With the "higher-for-longer" interest rates established by the Federal Reserve, small caps have felt a lot of pain and could continue to feel it.
As a result of higher interest expenses, small caps aren't producing the outsize profit growth that's led them to outperform large caps historically.
But the tide is turning for small caps
With small-cap stocks trading at historically low valuations, it could be a great opportunity to buy shares in a small-cap ETF before the economic environment turns around.
It's very possible the Fed is done raising interest rates. Practically no one expects the Fed to raise interest rates next month at its next meeting. Meanwhile, 24% of futures traders believe it could lower rates as soon as next March. That could be a major relief to many companies that are particularly susceptible to interest rate changes, setting the table for stronger earnings growth from small caps.
That said, there's still the risk of entering a recession. That would likely see interest rates come down much faster but have far more deleterious effects on small companies. One way to protect against that possibility is to invest exclusively in profitable companies like those found in the S&P 600 small-cap index.
Three ETFs to consider for the small-cap opportunity
There are a bevy of small-cap ETFs you could choose from. I'm highlighting three options based on your risk tolerance and goals, but there are plenty more to choose from.
- SPDR Portfolio S&P 600 Small Cap ETF (SPSM 0.95%). The S&P 600 includes companies with market caps between $850 million and $5.2 billion who have reported positive profits over the most recent quarter as well as over the last four quarters combined. The SPDR ETF has the lowest expense ratio among its peers that also track the S&P 600 index, so it's a great option for those looking to invest specifically in profitable small caps.
- Vanguard Small-Cap Value ETF (VBR 0.81%). This Vanguard ETF seeks to track the CRSP US Small Cap Value Index. The index tracks companies in the bottom 15% of publicly traded stocks by market cap, so it's not as exclusive as other small-cap indexes. That said, the Vanguard Small-Cap Value ETF has a lower expense ratio than just about any other small-cap value index fund. The reason small-cap value may appeal to you is because it has been the hardest-hit segment of the market recently -- by far. Additionally, Small-Cap Value has historically outperformed small caps and the market as a whole.
- Avantis US Small Cap Value ETF (AVUV 1.28%). Investors seeking a little more active management might consider the Avantis Small Cap Value fund. It buys stocks in the Russell 2000 index trading at good value with strong profitability characteristics. This more active management style is more viable in less efficient small-cap markets than in large-cap stocks. Indeed, Avantis has been able to weather the storm over the past two years while the Russell 2000 index has struggled. With a modest 0.25% expense ratio, it may be worth picking up shares, but there's always a risk it underperforms the index.
Considering the heavy concentration in the S&P 500 right now, index fund investors should look to diversify away into smaller companies. Any of the above three ETFs would be the first place I look if I were thinking of investing more in index funds.
Adam Levy has positions in Apple. The Motley Fool has positions in and recommends Apple and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
