Why This Overlooked Vanguard Fund Could Outshine the S&P 500 in 2025

Large-cap stocks, especially mega-cap technology companies, have been the leaders in market performance since the Federal Reserve started its significant rate-hiking strategy. From March 2022 until November 2024, the S&P 500 achieved a total return of 38.3%, considerably higher than the Russell 2000 which managed only a 14.9% return.

However, two important trends indicate that this gap in performance might start to close. Firstly, the recent two-year surge in mega-cap stocks, spurred by advances in artificial intelligence (AI) and demand for obesity-related medications, has resulted in exceptionally high valuations. For example, semiconductor firm Nvidia is currently trading at 54 times its earnings, while pharmaceutical leader Eli Lilly has an even loftier valuation of 86.1 times earnings. This mismatch in valuations points toward attractive opportunities in the small-cap sector, where many stocks are available for less than 20 times earnings.

Secondly, with the anticipated election victory of President-elect Trump, there has been a revival of interest in small-cap stocks. Following the election, the Russell 2000 has outperformed the S&P 500 by about 3.23% (as of December 2, 2024). This administration is expected to advocate for pro-business policies that have historically favored smaller U.S.-focused companies.

A Cost-Effective Approach to Small-Cap Investing

The Vanguard Small-Cap Index Fund ETF Shares (VB -0.23%) presents a strong opportunity for investors looking to benefit from a potential shift in market dynamics. This fund includes 1,383 small-cap firms and boasts an impressively low expense ratio of just 0.05%. Additionally, its 30-day SEC yield of 1.35% enhances its appeal for capital growth.

The average price-to-earnings ratio (P/E) for the fund stands at 19.2, which is considerably below the S&P 500’s P/E ratio of 26.9. This difference in valuations indicates that as investors begin to shift their focus away from mega-caps, the small-cap space presents many opportunities. Although the small-cap fund's five-year average earnings growth rate of 14.2% is less than the S&P 500's 18.8%, this is attributed to the growth potential of smaller companies rather than any limitation on future profitability.

Diversification Meets Efficiency

The diversified nature of the Vanguard Small-Cap Index Fund ETF Shares helps protect investors from risks associated with individual stocks. Its largest holding, Axon Enterprise, constitutes only 0.5% of the total assets. Other significant holdings include paper and packaging manufacturer Smurfit WestRock plc, footwear brand Deckers Outdoor Corp., consulting firm Booz Allen Hamilton Holding Corp., and natural gas distributor Atmos Energy Corp., with each accounting for less than 0.45% of the total portfolio.

This broad level of diversification stands in sharp contrast to the concentrated allocations typical of the S&P 500, where just five tech giants—Apple, Nvidia, Microsoft, Amazon, and Meta Platforms—represent over 26% of the index. While this concentration has delivered substantial returns in the recent past, it also introduces increased risks, given that these tech stocks trade at premium valuations that may not be sustainable long-term.

A Complement to Warren Buffett’s Wisdom

In his 2013 shareholder letter, Warren Buffett advised sticking with a 90% allocation to a low-cost S&P 500 fund, like the Vanguard S&P 500 ETF. However, current market conditions suggest that it might be wise to adjust this approach.

There are two solid reasons for this adjustment. Firstly, the disparity in valuations between mega-caps and small-caps is at an unprecedented high. Secondly, Trump's expected pro-business orientation, including possible deregulation and increased spending on infrastructure, tends to favor small-cap companies. During Trump’s previous term, for instance, the Russell 2000 achieved a total return of 68.7%, thanks to tax reforms and initiatives that promoted domestic growth.

Though this figure was less than the S&P 500's 83.2% total return during the same timeframe, small-cap stocks today are priced much more attractively.

The Vanguard Small-Cap Index Fund ETF Shares presents an efficient way for investors to boost their exposure to this segment of the market, all while adhering to a low-cost, index-based strategy. Given the fund’s favorable valuations, potential regulatory tailwinds, and extensive diversification, now might be an opportune time for investors to enhance their S&P 500 holdings with this small-cap investment option.

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