You Can Do Better Than the S&P 500: Buy This ETF Instead

It’s not easy to beat the market. Only 8% of active large-cap fund managers have outperformed the S&P 500 over the last 15 years. Those who simply invested in an S&P 500 index fund, therefore, beat 92% of professional money managers.

If you want to invest successfully, one of your best options is to stick with the S&P 500. But what if you want even more growth? The Vanguard Small-Cap ETF (VB -1.37%) could be your best bet.

Always try to minimize this one thing

When it comes to investing in exchange-traded funds (ETFs), there’s one thing you should try to minimize: the expense ratio. This is what the fund charges you each year for investing in it.

Expense ratios vary widely. Some charge you 1% to 2% per year, while others charge as little as 0.01%. If you lose 1% or 2% of your assets to fees each year, that’s going to put a huge dent in your returns versus if you kept 99.9% of your money year to year.

Expenses are one of the leading reasons most professionally managed funds underperform the market over the long term. As index fund guru Jack Bogle once said, “Investors as a group must underperform the market, because the costs of participation — largely operating expenses, advisory fees, and portfolio transaction costs — constitute a direct deduction from the market’s return.”

Bogle founded The Vanguard Group in 1975 to help everyday investors avoid the big fees charged to them by other managers. Today, the company’s ETFs are some of the most cost-effective options available. And one in particular — the Vanguard Small-Cap ETF — has outperformed the S&P 500 for decades at a time, even after factoring in expenses.

This ETF can outperform the S&P 500

The S&P 500 is a large-cap index. Its portfolio is comprised of the 500 largest publicly traded companies in the U.S. So the index does not include small-cap companies, which historically have outperformed larger-cap stocks.

In general, small-cap stocks have shown more volatility over the decades than large-cap stocks. The reason makes sense: As smaller companies, these businesses have less scale, less access to capital, and are generally less proven. This elevated volatility, however, has produced above-average gains for investors willing to take on the extra risk.

According to Wellington Management, over any 10-year investing period, small caps have beaten large caps two-thirds of the time. Since 1927, this outperformance would have added 2.87% of annual returns to an investor’s portfolio.

One of the best ways to invest in small-cap stocks is through the Vanguard Small-Cap ETF. The fund tracks the CRSP US Small Cap Index, which includes 1,417 small-cap stocks. Its expense ratio is just 0.05%, versus an average of 0.99% for similar funds.

There’s one catch, however: Recently, small caps have underperformed large caps. This is a rare occurrence. From 2005 to 2020, for instance, the Vanguard Small-Cap ETF beat the S&P 500 by several percentage points.

Since then, however, it has lagged the market by a whopping 38%. This gap between small caps and large caps is the widest it has been since the dot-com bubble. “On a forward price-to-earnings basis, small caps are trading at 14x, versus large caps at 20x — a 30% discount,” Wellington Management says.

There is no secret to beating the S&P 500: Small caps have a long history of doing so. If you want to beat the market over the decade ahead, your best option looks to be a small-cap ETF like Vanguard’s, which offers instant exposure, low fees, and a historically low valuation.