Prediction: These 2 Overlooked ETFs Will Beat the S&P 500 Over the Next 10 Years

The S&P 500 has had an incredible run over the last two years. From the start of 2023 through the end of 2024, the benchmark stock index produced a total return of 58%. The bulk of that growth was driven by just a handful of companies. Specifically, the last two years saw the biggest companies get even bigger.

In fact, the top eight components of the S&P 500 have never accounted for a larger percentage of the index. A whopping 35.6% of the index's value is tied to the "Magnificent Seven" stocks and Broadcom.

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To be sure, those companies have seen strong financial results, many driven by advancements in artificial intelligence. But many large-cap stocks, including a handful of the Magnificent Seven, have seen their prices climb faster than their underlying fundamentals warrant. And that could lead to some mean reversion over the next few years after two years of huge gains in the index.

But if you look beyond the large-cap index, you might find several opportunities in the stock market. While the S&P 500 large-cap index has dominated that past 10 years, mid-cap and small-cap stocks present better expected returns over the next 10 years.

Image source: Getty Images.

Finding value in an expensive stock market

Investors focusing exclusively on the S&P 500 have seen stock prices climb considerably higher over the last decade by just about any valuation standard. The cyclically adjusted P/E (CAPE) ratio has climbed from the mid-20s in 2014, 2015, and 2016 to 37.5 today. The forward P/E for the index has climbed to 21.8 from the mid-teens 10 years ago.

That multiple expansion hasn't happened to smaller stocks. The S&P 400 mid-cap index and the S&P 600 small-cap index both currently trade for less than 16 times forward earnings. That's actually a lower multiple than each traded for in most of 2014 and 2015. The multiple expansion among large-cap stocks is almost entirely the reason for the S&P 500's outperformance over the last decade.

At this point, investors need to ask whether there's a good reason for large caps to command a higher multiple than smaller companies. On top of that, they have to ask whether large caps are in a better position to grow earnings faster than smaller companies. If large caps can't grow the bottom line faster, then a static P/E ratio will still lead to underperformance.

As it stands, the analyst consensus forecasts for earnings growth for the S&P 500, S&P 400, and S&P 600 are as follows:

Data source: LSEG Datastream and Yardeni Research.

While it's certainly possible for an individual large-cap company to live up to or exceed its valuation, large-cap stocks as a group appear fully valued. There's a lot more value to be found in small- and mid-cap stocks.

Warren Buffett agrees

Warren Buffett has been a net seller of stocks for the last two years after the last decade of strong returns propelled his company, Berkshire Hathaway, to a $1 trillion valuation. Much of that valuation is tied to its investable assets, which total over $620 billion.

But over the last two years, Buffett has been selling many of the large-cap stocks in Berkshire Hathaway's portfolio. He notably sold over two-thirds of his massive position in Apple over the last 12 months. Meanwhile, his few stock purchases this year are mostly concentrated on much smaller companies.

Unfortunately for Buffett, there are only a handful of stocks in which Berkshire can invest an amount of capital significant to the company. When you manage $620 billion, a company worth $10 billion isn't going to move the needle very much, even if you buy the whole thing.

Buffett lamented his current position at Berkshire's 2024 shareholder meeting, saying, "I would not like to be running $10 billion now; $10 million I think we, Charlie or I, could earn high returns on." In other words, all of the opportunities right now are in smaller businesses where getting down billions of capital is practically impossible, according to Buffett.

The two ETFs that could beat the S&P 500 over the next 10 years

Investing in a couple of simple index funds that track mid-cap and small-cap stocks may be enough to outperform the S&P 500. But smaller companies tend to have lower-quality businesses than large-cap stocks. As such, some quality filter can help improve returns over the long run.

Avantis creates exchange-traded funds (ETFs) based on a simple approach to filter its benchmark index to remove pitfalls like value traps and overweight exposure to undervalued stocks with higher profitability ratios. While the fund company is relatively new, its management comes from Dimensional Funds, which has a long track record of strong performance using a similar strategy.

The Avantis U.S. Mid Cap Equity ETF (NYSEMKT: AVMC) presents an excellent option for those interested in mid-cap stocks. While the index tilts toward value stocks, it includes growth stocks as well. With an expense ratio of 0.18%, it's priced well below traditional actively managed ETFs.

The Avantis U.S. Small Cap Value ETF (NYSEMKT: AVUV) uses a similar filter to weed out stocks and weight the remaining investment options. The big difference is a focus exclusively on value stocks. Small-cap growth stocks can offer the highest potential for returns on an individual basis, but more often than not they don't pay off for investors. As a group, it's better to avoid small-cap growth stocks in favor of high-quality value stocks. The Avantis fund offers one of the best ways to invest in small-cap value stocks, and it charges an expense ratio of just 0.25%.

There's no telling how long the large-cap stock outperformance will last. But based on current valuations and outlooks, smaller companies look like a much better investment right now. The above two funds are a couple of the best bets for outperforming the large-cap index over the long run.

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Adam Levy has positions in American Century ETF Trust-Avantis U.s. Small Cap Value ETF and Apple. The Motley Fool has positions in and recommends Apple and Berkshire Hathaway. The Motley Fool has a disclosure policy.