What Are You Really Paying For Inside VOO?

The popular index fund asks a higher price than its recent past, but the powerful growth of its biggest holdings makes a strong case for the premium.

Vanguard S&P 500 ETF (VOO) trades at a trailing price-to-earnings ratio of 28.2, a clear step up from its five-year average of 24.7. Before you even consider the stocks inside, that price presents a stark choice: the fund’s aggregate earnings yield of 3.5% is well below the 4.6% you can get from a 10-year US Treasury. The question is whether what’s inside this basket is growing fast enough to justify that trade-off.

A Price Tag With High Expectations

By the simple yardstick of its own history, VOO looks expensive. Today’s price is about 14% above the average P/E investors have paid over the last five calendar year-ends. You are paying more for each dollar of the S&P 500’s collective earnings than at almost any point in recent memory. An index fund has no star manager to justify a higher price; the value must come directly from the 505 positions it holds.

The Growth Engine Under the Hood

So, is that premium earned? The case for it rests on the powerful earnings growth of the companies that dominate the fund. VOO is heavily concentrated. Its five largest holdings make up 25% of the fund, so their story is, in large part, the fund’s story. Names like Nvidia at 7.5% of assets, Apple at 6.6%, and Microsoft at 4.3% are doing the heavy lifting. For these largest holdings, trailing twelve-month earnings per share grew about 56% over the past year. Looking forward, consensus estimates put one-year earnings growth for the fund’s holdings at about 18%. This expected growth is why the fund’s forward price-to-earnings ratio sits at a more moderate 19.5.

The Unavoidable Math of Risk

Here is the strongest argument for patience. With an earnings yield of 3.5% and a risk-free Treasury yield of 4.6%, you are starting with a negative risk premium. In plain terms, the market is not currently offering you a higher yield to compensate for the inherent risks of owning stocks versus a government bond. You are relying entirely on future earnings growth to generate a return above that risk-free rate. That growth may well arrive, but the current price offers no cushion if it disappoints.

What a Thoughtful Owner Should Weigh

The evidence suggests VOO’s elevated price is largely supported by the very strong growth of its biggest components. The trade-off is that you are accepting no immediate compensation for taking equity risk. When you buy an index fund, you accept this bargain. You own all the companies, at the price the market sets, in the proportion the index dictates. The alternative, for those uncomfortable with the current math, is to be more selective. For now, a key figure to watch is that 18% earnings growth forecast. If the fund’s holdings deliver it, today’s price will seem more reasonable in hindsight. If they don’t, the premium will feel much heavier.

How Do You Know You Picked The Right Fund?

VOO is paying up for fast-growing holdings. The real question is whether every fund charging a premium has earned it. An ETF gives you instant, diversified exposure to an idea, which is exactly why so many investors start there. The trouble is that a good idea bought at the wrong price makes a mediocre investment, and few ETF buyers ever check how their fund’s valuation and risk stack up against the alternatives. Our ETF Valuation and Performance Scorecard does that across the whole equity universe at once, ranking every fund by risk-adjusted return and then showing what each one costs versus its own history. And for the part of a portfolio where you would rather a system did the choosing, the Trefis High Quality (HQ) Portfolio holds 30 individually screened names, re-balanced by rule, with a track record of outpacing a benchmark that combines the three major indices – the S&P 500, S&P Mid-cap, and Russell 2000.