It’s a good idea to include exchange-traded funds (ETFs) in your investment portfolio, but with close to 3,000 to choose from in the U.S. alone, how can you decide which ones are best for you? The answer will generally depend on your circumstances, strategy, and investing philosophy, but one good way to start narrowing down your list is to compare their features and performance metrics.
The large-cap index ETF
The Vanguard S&P 500 ETF (NYSEMKT: VOO) is one of the largest ETFs on the market, and it’s a quintessential index fund. It tracks the S&P 500, which includes 500 of the largest U.S. companies by market cap. Its portfolio includes most major sectors and industries, and its long-term returns should reflect overall economic activity. When people talk about “the market” being up or down, they’re generally talking about this index.
The Vanguard S&P 500 ETF offers all the key benefits of index investing. Diversification dilutes the impact of company-specific issues and it limits volatility. Index investors will never enjoy the monster upside that a portfolio with a heavy concentration of a few growth stocks can conceivably deliver, but buying and holding index funds for the long haul is a simple strategy with a great track record.
The Vanguard S&P 500 ETF also provides that market-matching performance with a 0.03% expense ratio, which is as low as they come. Investors are paying fees of just $3 a year for every $10,000 they have in the ETF. Its holdings include a host of dividend payers, and the fund currently has a 1.5% yield. With extremely high trading volumes, the ETF is also among the most liquid investments out there.
This ETF doesn’t do anything fancy, but it’s extremely efficient. That’s why it’s so popular as a foundational piece for many investors’ portfolios.
The small-cap index ETF
The iShares Core S&P Small-Cap ETF (NYSEMKT: IJR) has been one of the most popular funds among investors over the past month. It holds a market-cap-weighted portfolio of 600 small-cap stocks that are selected by S&P. The selection methodology puts all of the obligations on a third party, so the fund’s passive approach keeps its expenses low. Investors should be pleased with the fund’s 0.06% expense ratio. Management fees can add up for investors over the long term, sapping your returns, but that’s not a concern here.
Small-cap investing comes with a unique blend of pros and cons. Many small-caps are young corporations or companies with niche focuses. As a result, the S&P SmallCap 600 Index is relatively more exposed to unstable, uncertain, and unprofitable companies, but many of them have enormous growth potential. Amazon (NASDAQ: AMZN) and Tesla (NASDAQ: TSLA) are now among the most valuable enterprises in the world, but they were once small caps.
As a whole, small caps tend to be more volatile than large caps, enduring bigger losses during broad market downturns, and proving more sensitive to company-specific bad news. However, many studies have shown that small-cap portfolios outperform the market over the long term. Of course, relative performance depends on the specific time frame in question — there have been long periods during which the biggest stocks triumphed.
It’s fair to expect the iShares Core S&P Small-Cap ETF to exhibit relatively high volatility over the long term, but investors should weigh its key performance metrics next to those of other small-cap investments, such as the Russell 2000. The iShares Core S&P Small-Cap ETF’s beta is below 1.0, which suggests relatively low volatility. It’s also very similar to the S&P 500 in terms of forward price-to-earnings and price-to-book ratios, and dividend yield. At this moment, don’t expect it to deliver performance that varies drastically from the market.
The better buy
Neither of these funds is inherently superior to the other, but they deliver different qualities to a portfolio. While they track different indexes, their passive methodologies are similar. These ETFs are also similar in expense ratio, liquidity, dividend yield, and valuation. Depending on your needs, either could be preferable.
For most investors, the Vanguard S&P 500 ETF should be a higher priority. That’s especially true if you use it as a base to support a handful of high-conviction individual stock holdings. If you’re looking for a higher-upside index investment and you can withstand more volatility, then the iShares S&P Small Cap ETF is a better option.
The small-cap index is likely to deliver better short-term results if we’ve hit a market bottom and a few months of gains are about to hit the stock market. If the market continues to slide due to recession fears and rising interest rates, then the small-cap index will probably fare worse than the large-cap index.
If you still can’t choose, consider buying both. They can be great complementary pieces in a portfolio.
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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Ryan Downie has positions in Amazon. The Motley Fool has positions in and recommends Amazon, Tesla, Vanguard S&P 500 ETF, and iShares S&P SmallCap 600 Index. The Motley Fool has a disclosure policy.