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The S&P 500 might not be as diversified as you would want from an ETF.
Investing in the Vanguard S&P 500 ETF (VOO -0.28% ) is a smart way to guarantee your fair share of the stock market's return.
The exchange-traded fund's (ETF's) low expense ratio, strong record of closely tracking the S&P 500 index, and simplicity make it appealing to new investors and seasoned veterans alike. Even Warren Buffett has some money in the index fund.
However, many investors might want to consider diversifying beyond the S&P 500. The index is currently heavily concentrated in just a few companies' stocks. Microsoft, Nvidia, and Apple account for over 20% of the index's value, as of this writing.
If you're looking to add more diversification to your portfolio, there are three ETFs that could be better options than continuing to buy the Vanguard S&P 500 ETF.
The S&P 500 is full of some of the most important companies in the world. But if you invest in a regular index fund like the Vanguard S&P 500 ETF, you'll end up mostly owning the biggest of the big. One way to correct that imbalance is to buy an equal-weight S&P 500 index fund like the Invesco S&P 500 Equal Weight ETF (RSP -1.08% ) .
This Invesco ETF invests its assets equally among all the constituents of the S&P 500. It rebalances once every quarter, ensuring weightings never vary too far from equal. So, even when Nvidia shares rocket 50% higher in a quarter, the fund manager will sell some and reinvest the profits into underperforming stocks at the end of each quarter.
The equal-weight index has historically outperformed the cap-weighted index. That hasn't been the case over the last decade or so as the performance of mega-cap stocks has outpaced the overall market returns. But over the long run, equal weighting benefits from investing more across a diverse range of companies.
The Invesco S&P 500 Equal Weight ETF will cost investors a bit more than the Vanguard S&P 500 ETF. Its expense ratio is 0.2%. Still, it's an inexpensive way to increase exposure to the other 497 companies in the S&P 500 that aren't Microsoft, Nvidia, or Apple. And despite buying and selling stocks every quarter, the fund has never distributed any capital gains to shareholders.
While the S&P 500 is often used as a barometer for the overall market, the total stock market is much bigger than the 500 or so companies that make up the index. There are over 3,000 stocks available in the market.
You could invest in the entire stock market by buying a total-market index fund like the Vanguard Total Stock Market ETF. But that index fund suffers from the same weighting challenges as the S&P 500 ETF. What's more, the expected return from the two are practically the same.
Instead, investing in a small-cap index fund can give you more exposure to the market beyond the top 500 companies. A separate small-cap fund allows you to specify how much you invest in smaller companies relative to your overall portfolio.
The Vanguard Russell 2000 ETF (VTWO -1.73% ) tracks the small-cap Russell 2000 index, which outperformed the S&P 500 for the 35 years from its inception in 1979 to 2014. Since 2014, however, large caps have dominated the market, outperforming small caps.
But there are several indications small caps could be poised for a comeback. The Vanguard Russell 2000 ETF offers low-cost exposure to the index with an expense ratio of just 0.1%.
Small-cap stocks have historically outperformed larger companies over the long run, and small-cap value stocks have done even better.
Focusing on small-cap value stocks means you're looking at small but often profitable businesses. These companies are more likely to survive an economic downturn, and they're less susceptible to fluctuations in interest rates since they aren't as reliant on debt.
While small growth stocks could be home runs, they will more likely be a strikeout for investors. Small-cap value stocks consistently outperform as a group.
One of the best ETFs for small-cap value investors is the Avantis U.S. Small Cap Value ETF (AVUV -1.97% ) . While technically an actively managed fund, it behaves more like a passive index fund. The managers set stock selection and weighting criteria based on profitability and valuation metrics, and invest in a diversified portfolio of 761 stocks. It aims to outperform the Russell 2000 value index.
With an expense ratio of just 0.25%, it's not too expensive, even compared to fully passive small-cap value funds. And the management team has a strong track record of performance, coming from Dimensional Fund Advisors.
Adam Levy has positions in American Century ETF Trust-Avantis U.s. Small Cap Value ETF, Apple, and Microsoft. The Motley Fool has positions in and recommends Apple, Microsoft, Nvidia, Vanguard Index Funds-Vanguard Total Stock Market ETF, and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.
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