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

One of the most popular index funds in the world is the Vanguard S&P 500 ETF (FLIGHT 1.08%). There’s a good reason for that. The exchange-traded fund (ETF) has a strong record of accurately tracking the benchmark S&P 500 index, and it charges a rock-bottom expense ratio to do so. It’s no wonder investors have trusted it with over $1 trillion in assets.

While the popular Vanguard fund does an incredible job at what it’s designed to do, investors should question whether buying an S&P 500 ETF is really what they need right now. If they’re looking for a diversified portfolio, they might be surprised to learn that 35% of assets in the fund are tied to just 10 companies. Likewise, nearly one-third of the fund is invested in tech stocks.

There are better ways to achieve a diverse portfolio. And while the S&P 500 has produced extremely strong returns over the last 15 years, the market is signaling these ETFs may provide better returns while providing greater diversification.

Here are three ETFs to consider before investing in the Vanguard S&P 500 ETF.

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1. An equal-weight S&P 500 index

Investing in an equal-weight index fund is a great way to ensure you remain diversified. An equal-weight index will rebalance the constituents of the index every quarter to ensure they all account for an equal piece of the pie. The Invesco S&P 500 Equal Weight ETF (RSP 1.27%) is a great option for the S&P 500 equal-weight index.

There are good reasons to expect the Invesco fund to outperform the Vanguard S&P 500 fund. First of all, historical returns are on its side. The Invesco fund has outperformed the S&P 500 index by an average of 0.57 percentage points annually since its inception in 2003.

Moreover, current economic trends are on its side. After a couple of years of slowing money supply growth (sometimes diving into negative territory), the U.S. money supply is starting to grow again. That trend should continue as the Federal Reserve loosens its monetary policy and lowers interest rates. A growing money supply generally correlates with reduced market concentration, as smaller companies have easier access to capital. That favors the equal-weighted index more than the top-heavy S&P 500 right now.

The biggest downside to the Invesco fund is that it has a relatively hefty expense ratio. It charges 0.2% per year to invest. Still, that’s less than the fund’s historical outperformance and should be worth the price given the current economic environment favoring a more diversified index.

2. A top small-cap index fund

Small-cap stocks saw a brief moment where investors appeared to be selling out of megacap stocks and buying into small caps. It started with some notable billionaires making bets on the popular iShares Russell 2000 ETF (IWM 3.19%) and gained steam in late July as interest rate cuts appeared imminent. However, the Russell 2000 index pulled back much faster as slow job growth suggested we could be heading for a recession.

Indeed, small caps are heavily reliant on the Fed navigating a so-called “soft landing.” That’s where it can start lowering interest rates without the economy falling into a recession. A recession would have an outsized negative impact on smaller companies, which are more susceptible to complete failure, than stable large-cap stocks found in the S&P 500.

Despite the setback, it doesn’t seem like we’re headed for a recession. The Fed appears poised to start lowering interest rates next month, which should benefit small-cap stocks. After several years of underperformance, small caps could be poised for stronger returns.

3. An ETF that focuses on small-cap value

Small-cap value stocks have historically outperformed any other segment of the market. And right now, small-cap value stocks offer extremely strong value relative to their large-cap counterparts.

The SPDR S&P Small Cap 600 Value ETF (SLYV 3.20%) has a forward price-to-earnings ratio (P/E) of about 14.1. The SPDR Portfolio S&P 500 Value ETF Value ETF (SPYV 0.99%) has a forward P/E of about 17.6. That gap makes small-cap value stocks even more attractive.

One of the best ways to invest in small-cap value stocks is the Avantis U.S. Small-Cap Value ETF (AVUV 3.50%). Avantis uses profitability and valuation metrics to select and weigh a portfolio of small-cap stocks with the goal of outperforming the Russell 2000 value index.

While its expense ratio is relatively high at 0.25%, it’s not going to break the bank. What’s more, it has the potential to earn its keep despite the higher fee, as small-cap value stocks look extremely attractive right now. While it’s not a purely passive index fund, it takes a more passive approach than typical active funds. The hybrid approach has produced strong results historically, and there’s no reason to expect that to change.