Investing doesn’t have to be complicated. A simple portfolio of exchange-traded funds (ETFs) may be all you need to earn excellent returns over the long term.
Many people will allocate their entire stock portfolio to one S&P500 or a total stock index fund. And while that can be an excellent foundation for any portfolio, history suggests that investors will do well to focus their positions on small-cap value stocks. That means putting more money into smaller companies trading at low valuations than you would get by investing in a total stock market index fund.
The easiest way to achieve that goal is through an ETF, and one of the best in this area is the Vanguard S&P Small-Cap 600 Value ETF (NYSEMKT: VIOV). And right now can be an ideal opportunity to buy shares. Here are five reasons why.
1. Small-cap value stocks have historically outperformed
We can look to history to see why it’s smart to add a small-cap value ETF to your portfolio. From 1926 through May 2023, small-cap value stocks outperformed the broader market. They returned 14.1% annually during that period, compared to 10% from the overall market.
However, that has not been the case recently. Small company value stocks have been beaten by large company growth stocks over the past decade. The S&P 500 growth For example, the index has returned 246% over the past ten years. The Russell 2000 value index has returned only 65% in the same period.
But that might make it an even better opportunity for investors to buy now.
2. Small-cap stocks are currently undervalued
Because small-cap values have underperformed so much over the past decade, the valuation gap between small-cap and large-cap stocks has rarely ever been this wide. The S&P 600 small-cap index has a price-to-earnings ratio (P/E) of 14.6, compared to a price-to-earnings ratio of 20.4 for the large-cap S&P 500.
The last time the valuation gap was this wide was in the early 2000s. That period was followed by strong outperformance of small-cap value stocks versus the S&P 500. The market could be preparing for another period of outperformance for small -cap value after years of languishing.
3. The Vanguard S&P 600 is more concentrated in small caps
Not every small-cap value fund is created equal. The Vanguard S&P Small-Cap 600 Value ETF has a greater concentration of small-cap stocks than its sister fund, the Vanguard Small-Cap Value ETF (NYSEMKT: VBR). According to Morningstar Research, the former is 100% invested in small-cap stocks. However, the latter holds around 30% of its assets in mid-cap stocks.
The difference comes from the index that each fund tracks. There is a hard market capitalization limit for inclusion in the S&P600, which currently stands at $6.7 billion. The Vanguard Small-Cap Value ETF tracks the CRSP US Small Cap Value Index, which covers the bottom 15% of stocks ranked by market capitalization. This results in a much wider range of shares in the index.
So if you want a more concentrated exposure to small caps, focusing on an ETF that tracks an index like the S&P 600 will yield better results.
4. Every company in the fund is profitable
What makes the S&P 600 different from other small-cap indexes is its profitability requirement for inclusion. Each company in the index must be profitable in the most recent quarter and the following four quarters.
Profitable companies historically generate better returns than unprofitable companies over the long term. That could come from better downside protection during market downturns, which can have a greater impact on smaller stocks than larger stocks.
As such, the S&P 600 index is a great candidate for finding the best small-cap stock investments.
5. The economic prospects are good
One of the biggest reasons for small cap underperformance lately is the uncertain economic outlook. Rising inflation has prompted the Fed to raise interest rates, raising concerns about a recession.
Rising interest rates hit small businesses harder than large corporations. Small businesses often use floating rate debt instead of long-term bonds, meaning higher interest rates have an outsized impact on their profits. Moreover, higher interest rates also prompt investors to demand higher risk premiums from risky small-cap stocks, further pushing down current prices.
Small-cap stocks also tend to underperform during recessions. And as fears of a recession mounted, investors may have pushed aside small-cap stocks.
However, the prospects are improving. The Fed has likely stopped raising rates and expects to start lowering them this year. Meanwhile, many believe we have avoided a recession. Both factors should boost the performance of small-cap stocks going forward.
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Adam Levy has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
5 Reasons to Buy the Vanguard S&P 600 Value ETF Like There’s No Tomorrow originally published by The Motley Fool
