This 2 ETF Portfolio Historically Outperforms the S&P 500 With Less Volatility

Building a portfolio that can produce better returns than the S&P 500 (SNPINDEX: ^GSPC) with less volatility is the exact thing that dozens of fund managers get paid huge sums of money to do. Unfortunately, most of them fall short of that benchmark once you account for their fees.

But you might not have to spend a lot to put together a portfolio that can achieve that goal. And it doesn't require complicated strategic balancing of individual stocks or sector ETFs. A simple 50/50 split between two ETFs has produced higher annual returns over multiple periods in the last thirty years, with lower annualized volatility over the long run and smaller maximum drawdowns than the S&P 500.

Here's the simple portfolio to consider, why it works, and whether it'll work for you.

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Can a 2-ETF portfolio really beat the S&P 500?

There are two factors that have historically produced excellent returns for investors: momentum stocks and quality stocks.

Momentum stocks, put simply, are stocks that have gone up the most in a given period. The S&P Momentum indexes use the 12-month price change, excluding the most recent month. The Invesco S&P 500 Momentum ETF (NYSEMKT: SPMO) tracks the relevant index.

It might be surprising that momentum stocks outperform. After all, these are companies whose stocks have already run higher over the last 12 months. Their valuations are often stretched. But the strength of momentum stocks appears to be a behavioral anomaly of the market. Investors have greater confidence in stocks that have already risen, especially in bull markets. And the stock market is often in a bull market. Systematically buying stocks that have gone up tends to outperform the S&P 500. Using an index fund that automatically adds and removes stocks based on recent momentum is an excellent system.

Quality stocks are those with high profitability, low financial risk, and strong cash-flow generation. The S&P Quality indexes use a quality score based on return on equity, net changes in operating assets, and the financial leverage ratio. The Invesco S&P 500 Quality ETF (NYSEMKT: SPHQ) tracks the relevant index.

Quality stocks are better positioned for a macroeconomic downturn and a market drop than other stocks. With strong balance sheets and high levels of profitability, they hold up very well relative to the rest of the market. Additionally, quality stocks usually keep pace with the broader market in months with positive overall returns.

How to combine ETFs to produce better returns

Both factors can produce better returns than the S&P 500 alone. The momentum factor outperforms as the market moves higher while typically limiting excess downside in bear markets. Quality stocks don't go up as much in bull markets, but they don't go down nearly as much when the market drops. But the analysts at S&P Global found that a 50/50 portfolio of the two produces better relative performance than either factor alone, with less volatility than the S&P 500 over the long run.

In a theoretical portfolio dating back to 1995, backtested through June of 2026, a 50/50 portfolio produced annualized returns of 14.17% versus 11.08% for the S&P 500. What's more, that's better than either individual index, with the S&P 500 Momentum Index producing a 14.07% return and the S&P 500 Quality Index producing a 13.96% return. That said, historical performance is not necessarily indicative of future results.

More recently, momentum stocks have drastically outperformed quality stocks. But the long-term thesis makes sense. Rebalancing semi-annually, as the analysts at S&P Global tested, should maintain exposure to lower-volatility quality stocks while delivering strong momentum-factor results in bull markets.

Investors can copy the strategy with the Invesco ETFs noted above. Both charge relatively small expense ratios of 0.15% (Quality) and 0.13% (Momentum), limiting the drag on returns. As a result, investors should be able to achieve excellent overall returns with the simple two-ETF portfolio.

Adam Levy has positions in S&P Global. The Motley Fool has positions in and recommends S&P Global. The Motley Fool has a disclosure policy.