John Bogle, the founder of the Vanguard Group, once told investors: "Don't look for the needle in the haystack. Just buy the haystack." Instead of choosing individual stocks, Bogle believed that it was smarter to invest in the entire S&P 500 -- since most professional fund managers couldn't beat the benchmark index over the long run.
To prove his point, Bogle launched the market's first index fund, the Vanguard S&P 500 Index Fund (VFINX 0.32%), in 1976. It passively tracked the S&P 500 index and charged lower fees than actively managed funds.
At the time, the critics derided it as "Bogle's Folly" and claimed this passive approach to investing was "un-American." The fund only raised $11 million upon its launch, which was well below its original target of $150 million, since many people didn't want to invest in a fund that merely matched the market instead of beating it.
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But Bogle was right. It you had invested $1,000 into that index fund at its inception and reinvested its dividends, your investment would be worth nearly $240,000 today. That equals an annual return of more than 11%. By comparison, 89.5% of all hedge funds underperformed the S&P 500 over the past 10 years, according to SPIVA Scorecards.
Back in 2000, Vanguard launched the exchange-traded fund (ETF) version of that fund, the Vanguard S&P 500 ETF (VOO -0.64%), to reach a broader range of investors. Unlike index funds, which could only be traded once a day, ETFs could be actively traded throughout the day. It also charged a low expense ratio of just 0.03%, compared to the index fund's expense ratio of 0.14%. So should you invest in the Vanguard S&P 500 ETF before the next market shift happens?
The four reasons to avoid the Vanguard S&P 500 ETF
The Vanguard S&P 500 ETF might seem like an simple way to passively profit from the stock market's growth, but investors shouldn't overlook its four biggest weaknesses.
First, it allocates 34% of its portfolio to the information technology sector -- which houses some high-growth but volatile stocks. Its three biggest holdings -- Nvidia, Microsoft, and Apple -- account for 8.1%, 7.4%, and 5.8% of its portfolio, respectively. The growing weight of those stocks in the S&P 500 index reduces its overall diversification and exposes it to the tech sector's wilder swings. Many of the top tech stocks also perform well during bull markets but struggle during bear markets.
Second, the S&P 500 currently trades near its all-time highs with a historically high price-to-earnings ratio of 30. So even though Bogle said it's smart to buy the entire haystack, Warren Buffett famously warned investors to be "fearful when others are greedy." A lot of that rally was fueled by the Magnificent Seven stocks, which account for a third of the ETF's holdings -- and those high-profile names might shed their premium valuations during a market downturn.
Third, the Vanguard S&P 500 ETF underperformed the Invesco QQQ Trust (QQQ -1.16%), another popular ETF that passively tracks the Nasdaq-100, over the past 10 years. Since QQQ includes the same Magnificent Seven stocks as VOO but isn't weighed down by the slower-growth S&P 500 stocks, it might be a better growth-oriented play.
Lastly, the S&P 500 only includes U.S. companies. Investors who want to profit from the growth of overseas markets should check out the more globally diversified ETFs instead.
The one reason to invest in the Vanguard S&P 500 ETF
Investors should be aware of those shortcomings, but it still makes sense to invest in the Vanguard S&P 500 ETF because its benchmark index has generated an average return of more than 10% annually ever since its inception in 1957.
So even if the index pulls back this year, it should head higher over the long term as long as the American economy keeps growing. If you're a long-term investor who plans to buy and hold this ETF for at least the next decade, you shouldn't fret too much about its current valuations.
Should you invest in this ETF before the next "market shift"?
Based on the S&P 500's current valuations, the next market shift might be a pullback instead of a rally. Yet I believe investors should still accumulate this ETF because it's futile to predict when the market will reach its near-term peak. Over the long term, the patient investors who dollar-cost average into this ETF could reap some impressive returns.
