1 Heavily Diversified Vanguard ETF That Could Outperform the S&P 500 in 2026

Let's be clear. The Vanguard S&P 500 ETF (NYSEMKT: VOO) is an excellent long-term investment vehicle, and so are other low-cost S&P 500 ETFs. Even if you buy at an all-time high, history shows that the S&P 500 is still a great wealth-building tool for investors who measure their returns in decades.

However, there are some major drawbacks of the S&P 500 that investors should be aware of. For one thing, the S&P 500 is highly concentrated. It is a weighted index, meaning that larger companies make up more of its assets, and the rise of trillion-dollar tech companies has resulted in a top-heavy index. As its name suggests, there are 500 companies in the S&P 500, but the 10 largest make up more than 40% of an S&P 500 index fund's assets.

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There's also the more subtle issue that S&P 500 index funds are designed to match the performance of the market, not to outperform it. If your goal is to beat the market, by definition, you'll have to look elsewhere.

If it is indeed your goal to beat the market, one Vanguard ETF you may want to take a closer look at is the Vanguard Russell 2000 ETF (NASDAQ: VTWO). Not only does it solve the "lack of diversification" problem of the S&P 500, but there are some good reasons why it could be a great time to invest in this index.

The Vanguard Russell 2000 ETF in a nutshell

If you aren't familiar with the Russell 2000 index, it's the most widely used benchmark for small-cap stocks. As the name suggests, it is an index that tracks the stocks of 2,000 companies. The median market cap of a Russell 2000 component is about $3.3 billion, and just to name the extremes, the largest Russell 2000 stock right now is Credo Technology (NASDAQ: CRDO) with a $23.4 billion market cap, and the smallest components have market caps in the $150 million range.

To be sure, the Russell 2000 is a weighted index like the S&P 500. But because of the tighter range of market caps (the largest S&P 500 stock has a market cap about 110 times the median), as well as the fact that it has 2,000 stocks, no component of the Vanguard Russell 2000 ETF makes up more than 0.75% of the fund's assets. In short, it's a far more diversified ETF than the S&P 500.

Like most Vanguard products, the Vanguard Russell 2000 ETF has a minimal expense ratio of 0.07%. This means for every $1,000 you have invested in the fund, your annualized investment expense is just $0.70. (This isn't a fee you have to pay -- it will simply be reflected in the fund's performance over time.)

Why buy the Vanguard Russell 2000 ETF now?

It's a losing battle to try to precisely time the market. I have no idea whether the Vanguard Russell 2000 ETF will beat the S&P over the next few weeks or months.

Having said that, from a long-term investor's perspective, it looks like an excellent entry point into small caps.

For one thing, the valuation gap between large-cap and small-cap stocks hasn't been this wide since the 1990s. To illustrate this, consider that the average S&P 500 stock trades for 29 times earnings and for 5.2 times book value right now. The average Russell 2000 component has a P/E ratio of 18.3 and trades for just 2 times book value. The last time the gap was this wide, small caps proceeded to outperform large caps for more than a decade.

There could also be some excellent catalysts that favor small caps over the next few years, especially the expected drop in interest rates. One big reason is that small caps are generally more debt-reliant than larger companies, and lower interest rates mean lower borrowing costs. The generally loose-regulation nature of the current administration could also help small caps compete more effectively with their larger counterparts.

The bottom line is that the Vanguard Russell 2000 ETF isn't going to double or triple your money quickly. But it could be an excellent way to build wealth over time, and that's especially true for those who buy while the valuation gap is still so wide.

Matt Frankel has positions in Vanguard Russell 2000 ETF and Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.