The S&P 500 (^GSPC 0.61%) has produced incredible returns over the last decade. The average annualized total return of the index over the last ten years is about 13.4% as of this writing. And that rate accelerated in recent years, with higher 5-year and 2-year averages.
Much of that growth has come from just a handful of stocks, which is fairly common for most periods in stock market history. What isn't common, however, is that the companies driving that growth were already some of the biggest companies in the index. What's more, those companies have all seen their price multiples expand significantly over the last few years as investors grow increasingly optimistic about their potential earnings resulting from investments in things like artificial intelligence.
But that leaves the index in a fairly precarious situation. Just eight big tech companies with relatively high valuations account for over one-third of the entire index's value. That led Goldman Sachs to update its long-term outlook in October of last year, estimating average returns of just 3% for the S&P 500 over the next decade. But there's a simple exchange-traded fund (ETF) that could produce total cumulative returns over the same period that are five times better than that, and investors should consider adding it to their portfolios.
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The two biggest drags on future returns
The analysts at Goldman Sachs provide two main reasons why they don't expect very strong returns from the S&P 500 over the next decade: valuation and concentration.
When it comes to valuation, the S&P 500 trades for a cyclically adjusted PE ratio (CAPE ratio) over 38 as of this writing. That's the highest level the stock market has traded at since the dot-com bubble -- save a few weeks in 2021. Before that, the index never reached a CAPE of more than 33. It's worth pointing out that each time the S&P 500 traded for a similar valuation, it led to the start of a bear market within the next year and a half.
The second factor that's concerning Goldman Sachs analysts is the concentration of the index in just a handful of companies. Highly concentrated indexes generally produce more volatile returns. And that makes sense since the biggest companies in the index can have a much bigger influence on its overall returns. The S&P 500 is currently more concentrated than it's been in over 100 years.
Higher potential volatility in and of itself doesn't mean future returns will be lower. But when you look at the current concentration in the context of valuation, Goldman Sachs' analysts suggest investors aren't properly accounting for this risk in the valuation of the market. As a result, there's much more downside potential than upside, skewing the analysts' forecast toward lower total returns over the next decade.
But there's an easy way to address both factors with just one investment.
Removing concentration and lowering the price
Not every stock in the S&P 500 trades for a high valuation. In fact, the biggest stocks in the index generally trade for significantly higher valuations than the smaller companies in the S&P 500.
The S&P 500 currently trades for a forward PE of about 21.8. The "MegaCap-8" followed by Yardeni Research, which consists of Alphabet, Amazon, Apple, Meta, Microsoft, Netflix, Nvidia, and Tesla trade for an average forward PE of 28.7. Meanwhile, the median stock in the S&P 500 trades for a forward PE of 18.8.
That massive discrepancy is why the Goldman Sachs analysts think the S&P 500 equal-weight index will outperform the cap-weighted index over the next decade. The equal-weight index diversifies the portfolio by tracking the performance of each component of the S&P 500 equally. And since it weighs the smaller companies trading at lower valuations the same as the high-valuation megacaps, it also has a lower overall PE compared to the S&P 500.
The outperformance could be significant. The analysts suggest the equal-weight index could outperform the S&P 500 by as much as 8 percentage points per year. However, they do offer this caveat: "This scenario may be too extreme given such a magnitude of equal-weight outperformance has not been realized in more than four decades. However, the equity market has also rarely been as concentrated as it is now." As a result, Goldman suggests a range of between 2 and 8 percentage points of outperformance is likely.
Based on the analysts' 3% average return outlook for the cap-weighted index, the equal-weight index could produce average returns of between 5% and 11%. Over a full decade, an 11% average annual return works out to a total return of 184%, versus just 34% for the S&P 500 at a 3% annual average. In other words, investors could get up to five times the total returns or more by investing in the equal-weight index.
The simplest way to invest in the equal-weight index is to buy the Invesco S&P 500 Equal Weight ETF (RSP 0.01%). The index fund has an expense ratio of 0.2%, which is higher than most S&P 500 index funds. However, the potential outperformance over the next decade could be well worth the price. And while the equal-weight index generally has higher turnover than the cap-weighted index due to constant rebalancing, the fund manager has never produced a capital-gains distribution for shareholders. So, you probably don't have to worry about any added tax implications.
Investors worried about the high valuation and concentration in the S&P 500 could do well to shift more of their portfolio to the Invesco ETF amid the current environment.
