Alternatives to plain vanilla S&P 500 exposure?
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Investors holding the S&P 500 are on track to earn returns exceeding 25% for the second consecutive year. Driven by large-cap growth stocks, broad U.S. market-cap indexes have once again proven their value in stock portfolios. The S&P 500 continues to deliver impressive performance, but after consecutive years of outperformance, concerns are mounting about its ability to sustain this positive momentum.
The S&P 500 year-to-date total return is 28%, powered by projected earnings growth of approximately 10%. This strong performance has pushed price-to-earnings ratios to their highest levels in two decades. Investors mindful of the SEC’s standard warning that “past performance is not indicative of future results” may want to explore alternative ways to gain equity exposure. Below are two non-market-cap ETFs with alternative approaches to weighting large-cap stocks.
Schwab U.S. Equity Dividend ETF
Schwab’s $68 billion dividend ETF, SCHD, pursues a dividend growth strategy. The index provider, Dow Jones, screens for stocks with at least ten consecutive years of dividend payments, a minimum float-adjusted market capitalization of $500 million, and minimum liquidity criteria. The index components are then selected by evaluating the highest dividend-yielding stocks based on cash flow to total debt, return on equity, dividend yield, and 5-year dividend growth rate.
SCHD holds 103 stocks and offers a 30-day SEC yield of 3.49%, more than double SPY’s 1.1% yield. Over the past five years, it has grown its dividend at an average annual rate of 12%. With a price-to-earnings ratio of 18.4 compared to SPY’s 28.1, SCHD provides a cost-effective option for investors seeking less expensive companies.
SCHD and SPY differ significantly in sector allocations and the average market capitalization of their holdings. SCHD has an 18.2% weighting in financials compared to SPY’s 14%, which could benefit from deregulation policies in the coming years. Additionally, SCHD allocates just 8.8% to the high-growth, high-valuation technology sector, far below SPY’s 31.2%. This reduced exposure to technology may shield investors if the AI-driven momentum slows or if technology earnings growth decelerates next year.
A potential concern with SCHD is its relatively high concentration in its top ten holdings, which account for 40.5% of the portfolio. The three largest positions—Cisco, Bristol Myers Squibb, and Home Depot—each represent 4%-5% of the fund. These companies have a strong history of consistently paying and growing dividends. From a diversification standpoint, none of SCHD’s top ten holdings overlap with those of the S&P 500, making it a compelling, low-cost (0.06% expense ratio) complement to SPY or even a stand-alone alternative.
SCHD’s portfolio leans toward value stocks, in contrast to the growth-oriented S&P 500. Recently, value stocks have significantly underperformed their growth counterparts. If investors remain willing to pay a premium for growth stocks, SCHD’s performance could trail that of SPY.
Schwab’s U.S. Equity Dividend ETF’s 19.6% 2024 total return trails behind the S&P 500 by 8.4%, mainly due to the lower allocation to technology stocks and SCHD’s value bias. Over the last five years, SCHD annual average return is 12.7% versus SPY’s 15.2% return.
Astoria U.S. Equal Weight Quality Kings ETF
Astoria Portfolio Advisors is a relative newcomer to the giant ETF market, but its management team each has more than 20 years of experience in institutional portfolio construction. Astoria’s U.S. Equal Weight Quality Kings ETF, ROE, is its second fund launch and has gathered more than $150 million in assets.
What makes ROE interesting and unique is its equal weight allocation approach that emphasizes the quality factor while maintaining similar sector exposure to the S&P 500. After applying a liquidity filter, ROE screens each sector for stocks with more than a $5 billion market capitalization using proprietary metrics to rank stocks according to their quality, valuation, dividend potential and growth metrics.
These factors include return on equity, return on investment capital, price-to-earnings ratio, dividend yield, projected growth estimates, and earnings momentum. The metrics used evaluate each factor vary by sector. The top 100 ranked stocks are selected for the Fund on an equal-weighted basis.
ROE’s 25.2% total return in 2024 has mostly kept pace with the S&P 500, but has beat the equal weight ETF, RSP, by a wide margin. Since its launch in August 2023, ROE has outperformed the S&P 500 equal weighted index by 6.4%. Astoria founder, John Davi, attributes the outperformance of the fund to the selection of companies with better earnings growth and sales metrics than those of the S&P 500 equal weighted index.
For instance, ROE has achieved 11.6% earnings growth, significantly outperforming RSP’s 1.9%. Similarly, ROE has delivered 12.1% sales growth compared to RSP’s 7.5%. Despite these differences, both funds have a similar price-to-earnings ratio of approximately 17.
“Most broad-based equal-weighted indices tilt towards the small and midcap value factor, and we think you should be tilted towards high-quality stocks,” Davi says. “Quality beats all other factors over long periods on a risk-adjusted basis.”
With an expense ratio of 0.49%, the Astoria Quality Kings ETF is pricier than most market-cap-weighted ETFs. However, its institutional-grade portfolio construction and historical outperformance relative to the basic S&P 500 Equal-Weight Index make it a strong alternative to both the traditional S&P 500 and its equal-weight counterpart.
Does It Make Sense To Diversify Away From the S&P 500?
As with most portfolio decisions, moving from simple market-cap-weighted portfolios to alternative strategies comes with both advantages and drawbacks. Replacing S&P 500 exposure with an equal-weight ETF like RSP introduces a tilt toward smaller-cap stocks, while opting for a dividend growth ETF like SCHD adds a value bias. Choosing a quant-focused ETF like ROE may involve higher costs but targets specific factors, such as quality.
There’s no definitive answer when it comes to diversifying away from the traditional S&P 500. While the plain vanilla approach has delivered strong results in recent years, incorporating alternative strategies can enhance diversification. The key is ensuring investors are comfortable with the potential trade-offs, including some deviation from benchmark performance.