One of the easiest and smartest investments any investor can make is buying an S&P 500 index fund such as the SPDR S&P 500 ETF (SPY 0.95%) or the Vanguard 500 Index (VOO 1.00%).
The S&P 500 contains 500 of the top large-cap U.S. stocks and is regularly updated to weed out underperformers and add in rising stars, doing the hard work of rebalancing your portfolio for you and ensuring that the index contains the healthiest companies. The S&P 500 index fund is so successful that even Warren Buffett's own will instructs that 90% of his wealth passed on to his family be put in a low-cost S&P 500 index fund.
Image source: Getty Images.
A better option
The S&P 500 is a great choice for long-term investors as the index has a historical track record of returning on average of 9% a year with dividends reinvested.
However, the stock market is cyclical, and we're at a specific moment in the market cycle right now. Stocks crashed in 2022 as interest rates surged but have begun to recover in 2023 as the economy has proven to be resilient, generative artificial intelligence sparked a boom in tech stocks, and interest rates seem to have peaked.
According to some, we're already in a new bull market, though others believe that a new bull market hasn't started until the S&P 500 sets a new all-time high. Regardless of the definition, history has shown that there's another index that consistently outperforms the S&P 500 in early-stage bull markets.
That index is the Russell 2000, which holds around 2,000 small and mid-cap stocks. The stock market pop last Tuesday offered the latest evidence of this pattern. Stocks rose broadly after the October Consumer Price Index report showed that inflation had cooled more than expected last month, making it less likely that the Federal Reserve will raise interest rates again. While the S&P 500 rose 1.9% on that day (Nov. 14), the Russell 2000 soared 5.4%. The small-cap index nearly tripled the growth of its large-cap peer.
Part of the reason for that difference is that the small-cap index has largely missed out on the recovery this year. As the chart below shows, the S&P 500 has still outperformed the Russell by a wide margin.
In other words, the Russell 2000 is still well off of its earlier peak during the pandemic, down 26% from the top in late 2021. The S&P 500, by comparison, is down just 6.5% from its peak in early 2022.
Using their all-time highs as benchmarks for their potential gains in a recovery, the Russell 2000 has a clear edge here. That's one reason to bet on a Russell 2000 ETF like the iShares Russell 2000 ETF (IWM 0.96%) in a recovery over an S&P 500 ETF. Let's take a look at another one.
History repeats itself
Small-cap stocks tend to be more volatile than their large-cap peers, and that makes sense. After all, small caps tend to be more risky, are more likely to be unprofitable, and are more likely to go bankrupt in a recession. That risk makes them more volatile, meaning they fall further in bear markets and rise faster in bull markets, especially in the early stages when investors can take advantage of beaten-down valuations. Small-cap stocks also tend to be more sensitive to interest rates, which is part of the reason why they've struggled this year.
But investors can use that volatility to their advantage. Looking back at the last two early-stage bull markets, you can see that the Russell 2000 outperformed the S&P 500 by a wide margin.
During the great financial crisis, the S&P 500 bottomed out on March 9, 2009. While both indexes did well over the next five years, you can see from the chart below that the Russell 2000 significantly outperformed the S&P 500 during that time.
Similarly, the Russell 2000 beat the S&P 500 in the five years starting from Oct. 9, 2002, its bottom following the dot-com bust.
In the market rally in 2020 after the COVID-19 sell-off, the Russell 2000 was also the winner in the year following the S&P 500 bottom on March 23, 2023.
The bifurcation between the two indexes in November seemed to come in part from Pfizer's announcement that its coronavirus vaccine was 90% effective, which led to more bullish bets in the stock market.
In the stock market, history often repeats itself, and the economic cycle has some predictability. For example, the Federal Reserve expects the federal funds rate to ease to 2.5% over the long run, down from the 5.25% to 5.5% range it is currently. A more accommodative monetary policy should help provide a tailwind for small-cap stocks over the coming years in addition to the expected stock market recovery.
Small-cap stocks have lagged in the recovery thus far, but Tuesday's pop shows that that pattern won't last forever. As signs mount that interest rates have peaked and investors begin to prepare for an economic recovery, buying the iShares Russell 2000 ETF gives you an excellent chance of outperforming the S&P 500 over the next five years.
