Why Would Anyone Buy SCHB Instead of MAGS?

The "Magnificent Seven" have been some of the hottest tech stocks in the world for the past several years. Alphabet, Apple, Amazon, Meta Platforms, Microsoft, Nvidia and Tesla are household-name companies that are widely known for innovation and constantly being in the news.

Although the "Magnificent Seven" stocks have driven a large share of stock market growth in the past few years, they might be losing their luster. An exchange-traded fund (ETF) that tracks the Magnificent Seven, the Roundhill Magnificent Seven ETF (NYSEMKT: MAGS), has underperformed the S&P 500 index year to date. The past few years' high returns from the Magnificent Seven might look tempting, but there's no guarantee those seven stocks will keep beating the market in the long run.

Instead of buying the Magnificent Seven ETF, many long-term investors might be better off buying a diversified stock market index fund like the Schwab U.S. Broad Market ETF (NYSEMKT: SCHB). This low-cost index fund tracks the Dow Jones U.S. Broad Stock Market Index, and it's up 8.4% year to date, which is also outperforming the Magnificent Seven ETF (which is up 5.9%).

Let's look at a few reasons to buy SCHB instead of MAGS.

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SCHB: 2,414 stocks with 10 years of 14.7% returns

The Schwab U.S. Broad Market ETF is intended to give you exposure to the 2,500 largest publicly traded companies in the U.S. market. As of May 14, the fund owns 2,414 stocks, which include large-cap, mid-cap, and small-cap companies. For the past 10 years, this ETF has delivered annualized returns (by net asset value) of 14.7%. And it charges one of the lowest expense ratios: 0.03%. There are reasons this ETF ranks among the best low-cost index funds.

The top five holdings in the Schwab U.S. Broad Market ETF are all major tech names -- in fact, they're all members of the Magnificent Seven:

• Nvidia (7.9% of the fund)
• Apple (6.1%)
• Alphabet (5.8%) (including Class A and Class C shares)
• Microsoft (4.2%)
• Amazon (3.6%)

However, SCHB is broadly diversified. Information technology stocks make up only 31.1% of the portfolio. The fund also holds solid percentages of financial stocks (12.9% of the fund), industrials (10.3%), healthcare (9.9%), consumer discretionary (9.9%), and other sectors.

Owning the Schwab U.S. Broad Market ETF doesn't mean you have to stop owning tech stocks. This fund gives you access to some tech stock upside, without putting too many eggs in a tech-loaded basket. And if other parts of the U.S. economy start to outperform tech stocks, this fund will automatically shift and rebalance, as new winners get chosen by the market.

MAGS: 7 tech names, 34.2% annualized returns since April 2023

Indeed, the Magnificent Seven tech stocks have strongly outperformed the rest of the market for the past few years. The Roundhill Magnificent Seven ETF was established in April 2023, and since then, the fund has delivered annualized returns of 34.2% for almost the past three years (as of March 31).

This ETF does just what its name promises: it holds seven stocks. The Magnificent Seven names in this ETF are rebalanced to an equal weight on a quarterly basis, so each company makes up about 14.2%-14.3% of the fund. The Roundhill Magnificent Seven ETF charges an expense ratio of 0.30%, which is not the most expensive fee in the world, but is 10 times the fee charged by the Schwab U.S. Broad Market ETF. That fee seems a little high for seven stocks that you could buy yourself with fractional shares in a brokerage account.

Here's another problem with buying the Magnificent Seven ETF: not all seven stocks have been winners lately. For the past year, Alphabet, Nvidia, and Apple have strongly outperformed SCHB, but Tesla, Meta, and Microsoft have underperformed. (Meta and Microsoft have delivered negative returns in the past year.)

GOOG Total Return Level data by YCharts

If this divergence in performance continues, the Magnificent Seven might not be a winning team anymore. If you're going to take such a concentrated risk on a single-digit number of tech stocks, you might as well just buy individual shares of companies like Alphabet, Apple, and Nvidia, and ignore the rest. Or, if you want to go long tech stocks, consider buying the Invesco QQQ ETF instead of MAGS. Just buying the Nasdaq-100 could give you plenty of tech-driven upside without risking too much on only seven stocks.

Why buy SCHB instead of MAGS?

Investment fads come and go. Last year's hottest stock trend might become tomorrow's big loser. There's no guarantee that the same seven tech stocks will keep beating the market for long -- in fact, three of them have underperformed for the past year.

Instead of betting too heavily on seven stocks, most long-term investors are likely going to be better off with diversification -- owning thousands of stocks instead of just seven. And that strategy makes the U.S. Broad Market ETF a better buy for most investors than the Magnificent Seven ETF.

Ben Gran has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Alphabet, Amazon, Apple, Meta Platforms, Microsoft, Nvidia, and Tesla. The Motley Fool has a disclosure policy.