Vanguard’s S&P 500 ETF Will Thrive After The AI Party Ends (NYSEARCA:VOO)

The Vanguard S&P 500 ETF (NYSEARCA:VOO) is one of my longest-standing portfolio holdings. Having bought a few thousand dollars’ worth of VOO during the March 2020 COVID-19 market crash, I’ve had good results with it. Since initiating my position in VOO, I’ve gained about 70% and received some dividends to boot. Not a bad showing, all things considered.

Generally speaking, investors are well advised to hold index funds like VOO. Such funds offer a lot of diversification; indeed, a level of diversification that is nearly impossible for individual investors to get in individual stocks. The cost of recreating the S&P 500 in your own portfolio would be thousands of dollars if you have a broker charging a $5 fee per trade. If you have a no-fee account, you might also incur costs in the form of unfavorable bid-ask spreads. With VOO, you can get the entire index in your portfolio for a miniscule 0.04% management fee. What more could you want?

In addition to the generic benefits of indexing, the S&P 500 specifically has benefitted from the rise in spending on generative AI over the last few years. Despite the 10-year treasury yield having risen precipitously in 2022 and 2023, the S&P nevertheless rallied in 2023 and 2024, because of the money being made in generative AI. Top AI stocks like NVIDIA (NVDA), Alphabet (GOOG) and Microsoft (MSFT) made big gains in the period, in some cases because of actually profiting off AI, and in other cases because investors expected them to profit from it. In any case, the massive investment in AI paid off well for VOO and its unit holders.

Indeed, I believe that an investment in VOO is one of the best ways to play the generative AI trend today. On the one hand, AI is a long term secular trend that is expected to measurably increase U.S. GDP. On the other hand, we are coming up on two years of very hot gains in big tech stocks, brought on by generative AI. There are good reasons to still be bullish on AI stocks, and there are also reasons to be bearish on them. The valuation factor is not in the AI stocks’ favor, and there are legitimate concerns about their products becoming commodified. The chatbots offered by OpenAI, Microsoft, Alphabet and META all do basically the same thing: answer questions and generate images. It’s partially for this reason that Mark Zuckerberg said it would take years for META’s AI investments to turn a profit. When investors realize this, some of the luster could come off the AI stocks.

When I last covered the Vanguard S&P 500 Fund, I rated it a ‘buy’ on the grounds that it was well diversified and cheap (cheap in the sense of low fees not low valuations). Despite VOO having run up in price since I last covered it, I’m even more bullish on it now, the reason being that it is very well positioned in the AI Arms Race. While tech sector funds like the Invesco QQQ Trust (QQQ) offer even more AI exposure than VOO, they are not very well diversified, typically holding a few dozen to a hundred stocks, all of them highly correlated with one another. To make such a concentrated bet on big tech right now requires a lot of conviction in the resilience of the generative AI trend–conviction that this author doesn’t quite possess. On the other hand, VOO offers AI exposure much like the QQQ and its ilk, but with plenty of out of favor names as well. This makes it a better-diversified fund than an all-tech portfolio, and an investment in it better (from a risk management perspective) than an above-index allocation to big tech. For these reasons, I consider VOO a strong buy today.

Generative AI: The Trillion-Dollar Question

Generative AI, specifically its ability to deliver on its promise of productivity improvements, is the trillion-dollar question hanging over the markets in 2024. After ChatGPT launched in 2022, it reached 100 million users faster than any other app in history at that point (it was later eclipsed by Threads). It took ChatGPT just two months to hit the 100 million user milestone. This growth story triggered a flurry of activity in everything generative AI related. Investors started demanding it, fund managers started buying it, and companies started extensively mentioning it in earnings calls. This obsession with AI was by no means limited to tech companies. Banks talked about AI frequently too (not just the investment opportunity, but the productivity gains they were seeing from it). Even railroads, among the stock market’s oldest dinosaurs, joined the party, boasting of productivity gains they were enjoying due to AI adoption!

There was plenty of money to be made in the early days of the AI Arms Race. Now, however, valuations are starting to look stretched. NVIDIA (NVDA) currently trades at 75 times earnings, 41 times sales and 68 times book. The “Magnificent Seven” stocks are generally trading at around 30 times earnings. Basically, a lot of the expected growth stemming from AI is being paid for. Also, the only mega-cap name to really see an explosion in growth from AI was NVIDIA. Although META, Microsoft and Google all did good EPS growth last quarter, the growth was mainly from cost cutting in the months leading up to earnings. Revenue growth at the three companies (except META) was relatively moderate. So, there hasn’t been an AI-driven revenue boost just yet.

Yet, the secular trends driving the AI boom remain in place. People still like getting AI written content; companies still want to boost productivity; and people want to do less busy work. All of these factors suggest that the demand for generative AI will last a long time. Potentially, it will last for the remainder of human history.

Faced with these mixed signals, it’s only natural for an investor to want some diversification. And that’s exactly what VOO has. By weighting, VOO is 12.4% financials, 12% healthcare and 10% consumer cyclicals. Collectively, the portfolio is 68.5% non-tech. This means that the fund’s AI exposure–which is substantial–is heavily offset by other sectors. In today’s market conditions, that’s probably a plus. The higher AI stocks climb, the more investors will start thinking about valuations. Going by the “headline” multiples, they are generally quite expensive already. In the meantime, you have banks trading at 14 times earnings and energy stocks at 11 times earnings. The comparative cheapness of these sectors may lead investors to purchase them instead of tech stocks if said stocks’ multiples rise even further than they’ve risen to date. Also, their presence in the S&P 500, even without considering catalysts, is a good form of diversification that makes the S&P 500 less risky than more concentrated investments.

Why You Want Financials, Energy and Utilities in Your Portfolio

The diversification benefit of having non-tech stocks in your portfolio is well established. In addition to that, stocks in the financials, energy and utilities sectors have well-known catalysts that make a strong case for outperformance going forward.

First, financials are seeing tremendous growth in their investment banking (“IB”) operations. Last quarter, most of the major banks saw high growth in their IB segments, driven by debt deals as well as stock underwriting. Citigroup (C) is saying that it expects such growth to accelerate in Q2. All of this bodes well for the banks, who underwrite AI deals. Also, the yield curve is not as steeply inverted as it was in the past, which may improve margins at the banks’ core lending operations.

Second, energy companies enjoy a favorable environment at the moment. Oil prices are relatively high by historical standards, and there are reasons to think that the high prices will persist. OPEC+ nations continue cutting output, demand for gasoline keeps rising, and the S&P Energy stocks trade at just 13 times earnings. This combination of growth catalysts and a cheap valuation is very intriguing.

It’s a similar story with utilities. They trade at 21 times earnings, which is pricier than oil and financials. However, they have a major catalyst ahead in the form of rate cuts. Utilities are among the most heavily indebted companies in the world; as a result, their profits tend to rise considerably when rates come down. Empirical research shows that utility stocks rise in price when the Fed cuts rates, making their performance “bond-like.”

Going by multiples, the sectors above are all out of favor compared to tech, with P/E ratios below that of the S&P 500. They nevertheless have growth catalysts: clear ones in the case of banks and energy, and a possible one in the case of utilities. Not as much of these companies’ future growth is being paid for, compared to tech companies. So, they could outperform in the years ahead.

VOO vs. The Competition: Why I Have Gone With Vanguard

Having explored a major catalyst that could take the S&P 500 higher, it’s time to explain why I have invested in VOO but not its competitors like the SPDR S&P 500 Fund (SPY) or the iShares S&P 500 Fund (IVV).

A big reason is fees. VOO’s management expense ratio is a mere 0.03%, roughly a third of the SPY’s fee. IVV for its part has VOO about matched on fees (it also charges 0.03%), as well as on volume/liquidity, but it does not have as long a track record as VOO does. Launched in 2000, IVV is a much later comer than VOO, whose mutual fund predecessor dates all the way back to 1976.

This is a meaningful fact. Although we all like to think of index funds as Pure index-tracking portfolios, the fact is that like other pooled investment vehicles, ETFs have human managers who can make mistakes. Manager errors show up in fund performance as “tracking error.” At times, this error can be significant. ETF managers have to buy shares according to index weighting, they have to deal with authorized participants in creating and redeeming units, and they may lend out shares to supplement fund income. All of these are human-handled tasks, and it is possible to do them poorly. For example, if a fund manager who lends out shares may find himself without the cash required to pay the appropriate amount of dividends. So, manager performance is a very real concern with index funds. Maybe not as pressing a concern as with active funds, but a real concern, nevertheless.

Vanguard’s longer experience in the index fund industry is therefore a major edge. When I compared VOO and IVV side by side, I found their actual levels of tracking error about the same, but the Vanguard Fund is a full 2% ahead of the iShares fund over 10 years according to Seeking Alpha’s charting tool. So either VOO’s tracking error is less severe, or it experienced ‘good’ tracking error leading to outperformance. This is consistent with my observation that the firm with more experience in running index funds should enjoy superior performance. So, I give VOO a very slight edge over IVV, making it my S&P 500 fund of choice. For investors with long enough holding periods for fees to be a concern, both VOO and IVV are vastly preferable to SPY.

Conclusion

In this market, everybody and their Dog is looking for ways to profit off of the massive growth in generative AI. AI software stocks, AI chip stocks, AI data centre stocks, all of these are being combed over with religious fervor by market participants. No doubt, some of these stocks will deliver the massive returns that investors are looking for. Many of them won’t, though.

Viewed in this light, an investment in the Vanguard S&P 500 ETF could be thought of as a lower risk way to get AI exposure in one’s portfolio. Big tech–including the big AI movers and shakers–represents a 31.5% share of VOO’s portfolio. The AI exposure is there. At the same time, VOO offers exposure to many out of favour sectors as well. So, from a perspective that takes into account both risk and return, The Vanguard S&P 500 Index Fund is preferable to 100% AI-focused portfolio. Other S&P 500 funds offer this advantage as well, but VOO, with its rock-bottom fees and decades-long track record, is among the best of the bunch.