High Stakes For VOO And SPY: The S&P 500's Lofty Valuations Put ETF Strategies To Test

Following a blistering 85% spike in just three years, the S&P 500 has returned to rarefied heights.

Vanguard S&P 500 ETF (NYSE:VOO) and SPDR S&P 500 ETF Trust (NYSE:SPY) are tracking the benchmark. It’s now at a forward price-to-earnings ratio of about 23, a level last witnessed during the dot-com era.

The present rally is fueled by the so-called “Magnificent Seven,” which boasts a staggering earnings expansion owing to artificial intelligence and cloud computing. They include Apple Inc (NASDAQ:AAPL), Alphabet Inc (NASDAQ:GOOGL), Amazon.com Inc (NASDAQ:AMZN), Meta Platforms Inc (NASDAQ:META), Nvidia Corp (NASDAQ:NVDA), Microsoft Corp (NASDAQ:MSFT), and Tesla Inc (NASDAQ:TSLA).

See Also: Record Global Exposure To US Equities Could Make Next Crash Far Worse Than Dot-Com Bust

These companies also make the S&P 500 more concentrated than ever before. Just 10 stocks now account for almost 40% of the index. That’s up from 27% at the peak of the dot-com bubble.

That risk of concentration is causing investors to re-examine vanilla market-cap-weighted ETFs such as VOO and SPY.

Same S&P 500 Exposure, Different Structure And Price

Brandon Rakszawski, VanEck Director of Product Management, said in a recent commentary that stretched valuations and heightened exposure might deter long-term return potential. He went on to say that investors were willing to pay that multiple as mega-caps continued to produce, but the margin for error is decreasing.

Though both VOO and SPY provide essentially the same S&P 500 exposure, they have slightly different structure and price. These differences might be more significant in an extended market. VOO, with an expense ratio of only 0.03%, is one of the lowest-cost methods of following the index.

SPY, the world’s oldest and most heavily traded ETF, costs 0.09% but offers unparalleled liquidity and narrower spreads, making it the preferred choice for institutional short-term traders. Effectively, VOO is resonating with long-term investors looking for efficiency, and SPY is the favorite among tactical and institutional participants— two facets of the same benchmark coin now confronting the same valuation challenge.

For investors looking for balance, options like the Invesco S&P 500 Equal Weight ETF (NYSE:RSP) or Avantis U.S. Small Cap Value ETF (NYSE:AVUV) have been popular options. These ETFs limit concentration risk by spreading weight more evenly or targeting underappreciated areas of the market.

The lofty multiple is asking uncomfortable questions: Can the market support these valuations without another decade of below-average returns? Historically, times when the S&P 500’s forward P/E has been above 22 have provided 10-year annualized returns ranging from -3% to 3%. And never have valuations in excess of 24x been followed by a decade of positive returns.

For the moment, the S&P 500 rally holds. But with valuations extended and concentration at historic highs, VOO and SPY are about to face their ultimate test: whether diversification is still about owning the index.

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