An S&P 500 Index Fund Already Owns These Financial Stocks. Here's Whether to Own More.

Exchange-traded funds (ETFs) that track the S&P 500 are the largest and most popular investments in the world for good reason. They provide access to the 500 largest U.S. companies, across sectors, providing diversification in one wrapper, at least among large-caps.

So when one sector, like financials, is struggling, another sector, like energy or technology, can pick up the slack.

The financials sector, for example, has been one of the worst performers over the past year. The 75 or so large-cap financial stocks within the S&P 500 are flat year to date on a cumulative basis, and they are up just 1% over the past 12 months.

An S&P 500 ETF provides access to the largest financial stocks -- like Berkshire Hathaway (NYSE: BRKA) (NYSE: BRKB), JPMorgan Chase (NYSE: JPM), Charles Schwab (NYSE: SCHW), Robinhood (NASDAQ: HOOD), Goldman Sachs (NYSE: GS), American Express (NYSE: AXP), and Visa (NYSE: V), to name a few -- that you definitely want in your portfolio. Do you need broader financial exposure than that?

Yes and no.

Image source: Getty Images.

Financials have struggled

While it wouldn't hurt to get broader exposure to financial stocks, I wouldn't invest in an ETF or individual stocks that focus exclusively on small- and mid-cap financials.

While some areas of finance, like regional banks, have had a resurgence due in part to relaxed regulations and a robust mergers and acquisitions (M&A) market for banks, the outlook is not great for financials right now.

The Fed just raised interest rates, which will increase the cost of borrowing and could hamper lending. Rising prices in an uncertain and sluggish economy are also not ideal for financials. Furthermore, amid a four-year bull market, with high stock valuations, the likelihood of a correction or downturn is higher. That would hurt investment management firms and brokerages.

On the other hand, diversification beyond large-caps is essential right now, given the high valuation of the S&P 500. The Shiller P/E ratio, which tracks the valuation of S&P 500 stocks over the trailing 10 years, adjusted for inflation, is near an all-time high at 41.59. The only other time it was this high was during the dot-com era, and a bear market followed.

Where to diversify

Investors should definitely broaden their portfolios to include small-cap and mid-cap stocks and ETFs, as well as value stocks and international investments.

Many investment strategists, including those at Vanguard, believe that the S&P 500 will underperform small-caps, value stocks, and international stocks over the next 10 years. The reason is a combination of overvalued large-caps, causing investors to rotate out of them, and the expansion of AI out to smaller, non-growth companies and international markets.

Value stocks are projected to be the best-performing asset class, according to Vanguard, with an average annualized return of 6.4% to 8.4% over the next 10 years. Small-caps are expected to return 4.7% to 6.7% over that period, while international ex-US stocks are targeted for a 4.5% to 6.5% annualized 10-year return.

Both growth and large-cap stocks lag, according to Vanguard's 10-year outlook. Large-caps are projected to average a return of 4.1% to 6.1%, while growth stocks are anticipated to see 3.6% to 5.6% annualized returns over the next decade.

Vanguard is not the only one making these projections. Most of the large financial firms anticipate international and emerging market stocks outperforming their U.S. counterparts over the next 10 years. Fidelity anticipates small-caps beating large-caps over the next five to 10 years.

So, while you don't specifically need an ETF that gives you broader exposure within the financials sector, you most definitely should invest in ETFs or stocks that provide access to value, mid-cap, small-cap, and international stocks. Within those ETFs, you'll get some exposure to financials, just not exclusively.

Portfolio diversification is always a good idea, but in the years ahead, going beyond large-cap and, more specifically, large-cap growth stocks, will be essential.

American Express is an advertising partner of Motley Fool Money. Charles Schwab is an advertising partner of Motley Fool Money. JPMorgan Chase is an advertising partner of Motley Fool Money. Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends American Express, Berkshire Hathaway, Goldman Sachs Group, JPMorgan Chase, and Visa. The Motley Fool recommends Charles Schwab and recommends the following options: short September 2026 $95 calls on Charles Schwab. The Motley Fool has a disclosure policy.