Many retail investors now are opting for a purely passive approach and going all-in on the S&P 500 for their stock exposure. It’s easy to understand why: the go-to US index has done exceptionally well over the past ten years. But the economic backdrop is different now, and in a higher inflation, higher interest rate world, its returns are likely to be a lot less stellar. So if you’re looking to invest in stocks over the next ten years, you may want to find a new set of winners.
Why not just hold the S&P 500?
Even if you’re passively choosing the S&P 500 as your main exposure to stocks, you are taking some active views. First, you’re betting that US stocks will keep outperforming global stocks (despite them already having outperformed global stocks for a record 15 years). Second, you’re wagering on a return of the trends that supported tech companies (like falling interest rates and macroeconomic stability). Third, you’re betting that the S&P 500 will be able to preserve its record premium to other regions or investing styles. And finally, you’re betting that the US dollar will stay at least as strong as it is now.
If you’re making those bets deliberately, then carry on. But if you’re making them because the S&P 500 is just your default choice, then you might want to think about some alternatives. Here are four to consider…
1: Go equal weight
If you still want to be exclusively invested in the US, but want a more balanced exposure, you could consider an equally weighted S&P 500 ETF, which holds every stock in the index in equal proportions, whatever its size or sector.
You’d still be betting on corporate America, but you’d have more exposure to smaller stocks, trading at cheaper valuations, than the S&P 500’s weightings would have given you. You’d likely have a higher exposure to companies that haven’t already done well, and lower concentration risk, meaning you’ll depend less on the performance of a few companies. (Almost 20% of the S&P 500 is weighted in just five stocks). You’d also have a much lower exposure to the tech sector and a higher exposure to materials, industrials, and real estate.
Since the equally weighted S&P 500 has a higher exposure to the real economy (and a lower one to sectors most sensitive to speculation), it tends to underperform when a bull market is dying out, and outperform in the early stages of an economic recovery. You can see how that played out in 2000 and 2008 (blue line).
Equally weighted S&P 500 tends to outperform after bubbles burst. Source: Finimize.
And if interest rates and inflation stay higher for longer, the equally weighted index might beat the S&P 500 by even more, as sectors linked to the real economy are likely to do better than tech in that environment.
US investors could consider the Invesco S&P 500 Equal Weight ETF (Ticker: RSP; expense ratio: 0.2%) while Europeans could consider the Xtrackers S&P 500 Equal Weight UCITS ETF (expense ratio: 0.25%).
2: Go global
Sure, US companies are highly innovative, profitable, and directly serve the world’s biggest economy and its important customer base. But investing is about more than finding the best businesses: it’s also about buying them at attractive prices. And by that measure, stocks from other places (i.e. international stocks) are tempting. While US stocks’ valuations are above their 20-year average, international stocks are below theirs. And as the chart below illustrates, international stocks are trading close to their steepest discount on record, relative to US ones.
International stocks are very cheap. Source: JP Morgan Asset Management
International stocks also have higher dividends, higher exposure to the real economy, and higher potential for sales growth and margin expansion. They might not look as good as US stocks today, but if you’ve got a longer-term investment horizon (ten years or more), they’re worth a look. They’ve got a lot more room for improvement, and that tends to be what generates higher returns. Last but not least, investors in international stocks are likely to benefit handsomely as international currencies rise against the US dollar, which has been unusually strong this year.
To have a broad and diversified exposure while maintaining a heavy weight in US stocks, US investors could consider the Vanguard Total International Stock ETF (VXUS; 0.07%), and European investors could consider the Vanguard FTSE All-World UCITS ETF Distributing ETF (expense ratio: 0.22%).
3: Go for more value
Value stocks may not be as attractive as they were when we called them the “opportunity of a lifetime”, but this group of stocks (generally ones with a low price in relation to their earnings, book value, or cash flows) still is trading at an attractive discount, relative to growth stocks and its own history.
Value stocks are cheap. Source: JP Morgan Asset Management
If the economy is indeed entering into a prolonged period of higher rates, higher inflation, higher volatility, and a comeback of the real economy, then value stocks would be likely to do well and could beat the S&P 500 by a few percentage points a year. That’s not just because value stocks provide more stable cash flows, but also because they’ve got a higher dividend yield and more real economy exposure – meaning, they’re underweight tech and consumer discretionary sectors versus the S&P 500, and overweight financials, healthcare, industrials, consumer staples, and energy. They would also likely benefit from a reduction in all the FOMO, speculation, and financial engineering that boosted growth stocks in the past.
For US investors, the Vanguard Value ETF (VTV; 0.04%) offers exposure to value stocks, generally. You could focus on value stocks in advanced economies with the iShares MSCI EAFE Value ETF (EFV; 0.35%) or in emerging economies with the SPDR S&P Emerging Markets Small Cap ETF (EWX; 0.65%). For European investors, the iShares Edge MSCI USA Value Factor UCITS ETF (expense ratio: 0.2%) is a generalist pick, while the iShares Edge MSCI World Value Factor UCITS ETF (expense ratio 0.3%) focuses on developed economy value stocks, and the iShares Edge MSCI EM Value Factor UCITS ETF (0.4%) focuses on emerging market value stocks. If that’s not enough, check our guide here.
4: Go smaller
If there’s one group of stocks that doesn’t seem to receive the attention it deserves, it’s small-cap stocks. These stocks aren’t just screening cheap versus their own history, they’re also trading at the largest discount to large-caps since the dotcom bust in 2000.
Small-caps are cheap. Source: Bank of America
Sure, small-cap companies are less profitable, have more volatile cash flows, and are more cyclical –and that all makes them riskier. That being said, they currently have a larger valuation cushion, more growth potential, bigger dividend yields, and a higher exposure to the domestic US economy. They’re a lot less exposed to the tech sector and a lot more exposed to the real economy, with an overweight in the industrials, financials, real estate, and energy sectors. That makes them more likely to benefit from a more inflationary environment. What’s more, trends like globalization, deregulation, and near-zero interest rates disproportionately benefited large companies in the past decade. With those trends likely reversing, small caps could outperform the S&P 500 by a nice margin over the next decade.
To invest in US small caps, consider the Schwab US Small-Cap ETF (SCHA; 0.04%) if you’re US-based, and the SPDR Russell 2000 US Small Cap UCITS ETF (R2US; 0.3%) if you’re based in Europe. For investors who want both cheap and small US stocks: Vanguard Small Cap Value ETF (VBR; 0.07%) may be a good option. And for those who want international, cheap, small stocks, the Vanguard FTSE All-World ex-US Small-Cap ETF (VSS; 0.07%) may fit the bill.
Don’t get me wrong, there’s no guarantee that these four alternatives will give you higher returns than the S&P 500 over the next decade. But given the low prospective returns of the S&P 500 and the added margin of safety that comes from better valuations, they certainly caught my eye. And even if they outperform by just a few percentage points a year, this could make a significant difference to your savings at the end of the decade. Now, of course, I’m not suggesting you replace all of your S&P exposure with those four options. But rotating at least some of it might boost your risk-adjusted returns. At least, that’s what I’ve been doing in my own long-term portfolio.
