Buy 2 Vanguard Index Funds to Beat the S&P 500 in the Next 5 Years, According to Wall Street Analysts

State Street Investment Management recently updated its global equities outlook. In the next five years, the S&P 500 (SNPINDEX: ^GSPC) is forecast to return 39%, while the S&P Mid-Cap 400 and S&P Small-Cap 600 are forecast to return 41% and 42%, respectively.

Investors can get exposure to those indexes by purchasing shares of the Vanguard S&P Mid-Cap 400 ETF (NYSEMKT: IVOO) and the Vanguard S&P Small-Cap 600 ETF (NYSEMKT: VIOO). Here are the important details.

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1. Vanguard S&P Mid-Cap 400 ETF

The Vanguard S&P Mid-Cap 400 ETF measures the performance of 400 mid-cap stocks, defined as companies with market values between $8 billion and $22.7 billion. The fund has value stocks and growth stocks from every sector, but it is most heavily weighted toward three market sectors: industrials (24%), financials (15%), and technology (14%).

The top five holdings are listed below:

1. Ciena: 1%
2. Coherent: 0.9%
3. Lumentum: 0.8%
4. Curtiss-Wright: 0.7%
5. Flex: 0.7%

The Vanguard S&P Mid-Cap 400 ETF returned 365% (10.8% annually) over the last 15 years, while the S&P 500 returned 591% (13.7% annually) over the same period. One reason the mid-cap fund underperformed is due to a lower relative exposure to the technology sector, which has consistently delivered strong results.

The Vanguard S&P Mid-Cap 400 ETF has an expense ratio of 0.07%, meaning shareholders will pay $7 per year on every $10,000 invested. This index fund is a good option for investors seeking exposure to mid-cap stocks, but I doubt it will outperform the S&P 500 in the next few years (I'll explain why in the last section).

2. Vanguard S&P Small-Cap 600 ETF

The Vanguard S&P Small-Cap 600 ETF tracks the performance of 600 small-cap stocks, defined as companies with market values between $1.2 billion and $8 billion. The index fund includes value stocks and growth stocks from every sector, but it is most heavily weighted toward three market sectors: financials (18%), industrials (18%), and consumer discretionary (13%).

The top five holdings are listed below:

1. Solstice Advanced Materials: 0.6%
2. Arrowhead Pharmaceuticals: 0.6%
3. Moog: 0.5%
4. LKQ: 0.5%
5. InterDigital: 0.5%

The Vanguard S&P Small-Cap 600 ETF returned 360% (10.7% annually) in the last 15 years, underperforming the S&P 500 by 231 percentage points. But it beat the Russell 2000 (a benchmark for small-cap stocks) by 60 percentage points due to stricter eligibility criteria.

The Vanguard S&P Small-Cap 600 ETF has an expense ratio of 0.07%. This fund is a good option for investors seeking exposure to small-cap stocks. I think it will beat the Russell 2000 in the next five years, but I doubt it will beat the S&P 500.

Why I think the S&P 500 will outperform in the next five years

Index funds that track small-cap and mid-cap companies have a major drawback: The stocks that perform well are eventually removed because their market values top the prescribed thresholds. But the stocks that perform poorly remain put.

In that sense, small-cap and mid-cap index funds essentially sell winners and hold losers as time passes, and that is not a smart investment strategy. Famous fund manager Peter Lynch once warned, "Selling your winners and holding your losers is like cutting the flowers and watering the weeds."

The S&P 500 is a collection of winners that have already graduated from the S&P Small-Cap 600 and the S&P Mid-Cap 400. Additionally, the S&P 500 is reconstituted and rebalanced each quarter, which ensures it always tracks the most consequential U.S. stocks. That's why I'd rather own an S&P 500 index fund as compared to a small-cap or mid-cap fund.

Trevor Jennewine has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Ciena, Coherent, Curtiss-Wright, Lumentum, and Moog. The Motley Fool recommends Flex and LKQ. The Motley Fool has a disclosure policy.