Any way you look at it, the S&P 500 (^GSPC -1.11%) is absolutely crushing it these days. And it isn't just a post-election phenomenon. The S&P has skyrocketed well over 50% since the beginning of 2023.
Are S&P 500 index exchange-traded funds (ETFs) investors' best bets as the year draws to a close? I don't think so. Instead, I predict that one Vanguard ETF will outperform the S&P 500 over the next 12 months.
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A surging alternative to the S&P 500
Small-cap stocks have lagged well behind large-cap stocks in recent years. Value stocks have also underperformed growth stocks. Excitement about cloud services growth and generative AI have fueled impressive gains for the large-cap stocks that carry heavy weightings in the S&P 500 index.
Unsurprisingly, the Vanguard Small-Cap Value ETF (VBR -0.98%) hasn't delivered the kind of returns that several of Vanguard's funds that own large-cap growth stocks have. However, the story has changed over the last three months with this Vanguard ETF outpacing the S&P 500.
Technically, the Vanguard Small-Cap Value ETF doesn't own only small-cap value stocks. The median market cap of the 835 stocks in the ETF's portfolio is $7.5 billion, well above the $2 billion market cap at the upper end of the range for small-cap stocks. However, most of the Vanguard ETF's holdings are relatively small.
The "value" part of the Vanguard Small-Cap Value ETF's name is spot on, though. The average price-to-earnings (P/E) ratio of the stocks in the ETF's portfolio is 16.1. By comparison, the S&P 500's P/E ratio is close to 30.
Why this Vanguard ETF could beat the S&P 500
Valuation is one reason why the Vanguard Small-Cap Value ETF could beat the S&P 500 over the next 12 months. You might have heard the phrase "reversion to the mean." The idea is that when something is higher or lower than it normally is, it's likely to return to its normal level over time. The gap between the valuations of large-cap and small-cap stocks is much greater than it's been historically. I suspect it will narrow -- return to the mean -- with smaller stocks performing significantly better than larger stocks.
However, the primary factor behind the Vanguard Small-Cap Value ETF's recent outperformance versus the S&P 500 is that the Federal Reserve is lowering interest rates. Smaller companies tend to be more sensitive to interest rates than larger companies.
Investors are also looking ahead to changes that could be around the corner. In particular, the prospects of fewer regulations and corporate tax cuts are much higher now that the elections are over. Smaller businesses often encounter more challenges dealing with government regulations than larger organizations do. They also sometimes aren't able to navigate the complexities of the tax code as well as big companies can and feel the brunt of taxes more heavily.
The possibility that steep tariffs on all imports could be imposed might work more in favor of smaller companies than larger businesses, too. Smaller businesses tend to be focused more on the domestic U.S. market than international markets. Tariffs, therefore, might not hurt them as much as they would large companies and could protect some smaller businesses from foreign competition.
What could cause the prediction to unravel?
While I think my prediction that the Vanguard Small-Cap Value ETF will beat the S&P 500 over the next 12 months is based on sound reasoning, I'll readily admit that it could unravel. The weakest link in my case is the "reversion to the mean" argument. Although I'm confident that the valuation gap between small and large stocks will narrow, it might not happen to a significant degree over the near term.
Many economists project that across-the-board tariffs will lead to higher inflation. If they're right, the Fed's rate cuts could screech to a grinding halt. Even worse is a scenario where the Fed returns to raising interest rates to combat inflation. That would be bad news for the Vanguard Small-Cap Value ETF. However, my hunch is that the negative effects of any tariffs won't materialize enough by November 2025 to derail my prediction.
