There has long been one piece of advice provided by Warren Buffett: if you’re a nervous investor, invest long term in S&P 500 Index exchange-traded funds (ETFs) with low management fees.
But right now, that’s simply something I wouldn’t do.
These ETFs have become too risky given one factor. Today, we’re going to look at what that factor is and where investors may want to start investing instead.
Heavy on Big Tech
The market rally on the S&P 500 has seen shares climb past the US$5,000 mark already in 2024. Yet this rally could be seen as coming down to just a few stocks. And those stocks are the Magnificent Seven. These are companies you know, including Meta, Apple, Alphabet and more. This has made the index top-heavy, with smaller companies perhaps not doing as well.
The recent rally marked the 14th week of jumps in the last 15 weeks — something investors haven’t seen in over 50 years. The Index is now at the highest level investors have seen since the 1970s. And sure, those heavy hitters have proven to be quite valuable. Yet some have shown that they aren’t immune to market drops.
About half of the Big Tech firms so far saw a drop in share price, even when they didn’t announce earnings that missed estimates. And given they make up almost 30% of the S&P 500 and its market cap, that’s quite significant. And sure, earnings have proven strong. But the market is fickle, as we’ve seen. Shares could just as easily drop should we get more bad news on macro issues like interest rates and inflation.
Historically, big isn’t best
The largest stocks tend to actually do worse over time than their smaller counterparts, according to research by GMO Investment and Asset Management. Historically, the top 10 stocks tend to become expensive, and then when investors see value isn’t there anymore, they see a sharp drop in returns.
This adds up over time. Since 1957, the top 10 largest companies on the S&P 500 have actually underperformed the rest of the Index. And this could only become worse, given that in recent history, we’ve seen even more concentration.
You might be thinking I’m crazy, thinking that betting against these big tech stocks in 2023 would have been disastrous. And you’re right! But today, it’s a different situation, and that situation is a return to normalcy — a normalcy that, overall, could see the larger companies swell and decline. So, where might investors want to go instead?
Get on another index
If you’re a long-term holder and bought the S&P 500 at lower levels, then by all means, continue to hold. Or even better, consider selling and buying on another dip. But if you’re hoping to buy now and see similar growth from the last year, I wouldn’t hold your breath.
Instead, now is a great time to get in on a rally among other companies. And for that, I would look to ETFs that focus on the Russell 2000. In fact, analysts believe that the Russell 2000 is now primed for a breakout, with shares up 22% since bottoming out last year. And this earnings season, the Index has seen companies overall perform better as more than 80% of companies reporting thus far have beat estimates.
What’s more, the Russell 2000 doesn’t have the focus on the Magnificent Seven, compared to the S&P 500. So, overall, you’ll be getting a better deal and likely better performance. Therefore, it might be time to consider a Russell 2000 ETF, one such as iShares U.S. Small Cap Index ETF (CAD-Hedged) (TSX: XSU). This allows for exposure to the rally in United States stocks but is far more diversified. It seeks to track the Russell 2000, providing a 1.14% dividend as well!
