Buy 2 Index Funds to Beat the S&P 500 in the Next 5 Years, According to Wall Street Analysts

Key Points

State Street Advisors expect the S&P Small Cap 600 and the MSCI Emerging Markets indexes to beat the S&P 500 over the next three to five years.

State Street argues small cap and emerging market stocks will outperform due to strong earnings growth and cheaper valuations.

The S&P 500 crushed the S&P Small Cap 600 and the MSCI Emerging Markets indexes over the past decade, and the same outcome is possible over the next decade.

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In April, State Street updated its long-term asset class forecasts. The S&P 500 (SNPINDEX: ^GSPC) is projected to return 7.1% annually during the next three to five years, while the S&P Small Cap 600 and MSCI Emerging Markets indexes are projected to return 7.6% and 7.5% annually, respectively.

Investors can get exposure to those indexes by purchasing shares of the Vanguard S&P Small-Cap 600 ETF (NYSEMKT: VIOO) and the iShares MSCI Emerging Markets ETF (NYSEMKT: EEM). Here are the important details.

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Vanguard S&P Small-Cap 600 ETF

The Vanguard S&P Small-Cap 600 ETF tracks 600 U.S. companies that meet the definition of small-cap stock, which currently includes equities with market values ranging from $1.2 billion to $8 billion. The index fund owns stocks from all 11 market sectors, but its assets are concentrated in financial (18%), industrial (17%), consumer discretionary (13%), and technology (12%) stocks.

The five largest positions in the Vanguard S&P Small-Cap 600 ETF are as follows.

Eastman Chemical:0.5%Element Solutions:0.5%Primoris Services:0.5%Viavi Solutions:0.5%Argan:0.4%

The Vanguard S&P Small-Cap 600 ETF returned 180% (10.8% annually) in the past decade, while the S&P 500 posted a total return of 315% (15.2% annually). One reason small-cap stocks underperformed during that period was high interest rates, which typically have a disproportionate impact on small businesses because they rely more heavily on floating-rate debt.

The Vanguard S&P Small-Cap 600 ETF has a reasonable expense ratio of 0.07%, meaning shareholders will pay $7 annually over every $10,000 invested. While that is well below the average for U.S. index funds, it is still more expensive than the 0.03% expense ratio of the Vanguard S&P 500 ETF.

iShares MSCI Emerging Markets ETF

The iShares MSCI Emerging Markets ETF tracks about 1,225 companies across emerging market economies. It's most heavily exposed to China, Taiwan, South Korea, and India, but also includes stocks from Brazil, South Africa, and Saudi Arabia. The fund has a large percentage of its assets invested in three sectors: technology (32%), financials (21%), and consumer discretionary (10%).

The five largest positions in the iShares MSCI Emerging Markets ETF are as follows.

Taiwan Semiconductor:14.1%Samsung Electronics:6%SK Hynix:4%Tencent:3.2%Alibaba Group:2.3%

The iShares MSCI Emerging Markets ETF returned 133% (8.8% annually) in the last decade, while the S&P 500 posted a total return of 315% (15.2% annually). The primary reason U.S. stocks outperformed over that period was the dominance of U.S. technology stocks, particularly the "Magnificent Seven" stocks.

The iShares MSCI Emerging Markets ETF has a relatively high expense ratio of 0.72%, which means investors will pay $72 annually on every $10,000 invested in the fund.

Why investors should still prioritize an S&P 500 index fund (or U.S. large-cap stocks)

State Street believes U.S. small-cap stocks will beat the S&P 500 (U.S. large-cap stocks) in the next three to five years because of cheaper valuations and strong earnings growth. Indeed, small-cap earnings in 2026 are forecast to grow faster than large-cap earnings for the first time in years, according to FactSet Research.

However, small-cap companies are also more vulnerable to high interest rates, and the Iran war has made interest rate cuts much less likely. Investors entered the year expecting the Federal Reserve to cut rates by at least 50 basis points, so the Vanguard S&P Small-Cap 600 ETF has more than doubled the return of the S&P 500 in 2026. But if rate cuts fail to materialize, that outperformance could reverse.

Meanwhile, State Street also believes emerging market equities will outperform the S&P 500 over the next three to five years due to the devaluation of the U.S. dollar (which increases investment returns denominated in foreign currencies when converted back to U.S. currency), strong earnings growth, and relatively cheap valuations.

However, the vast majority of the largest technology companies are domiciled in the U.S., which means the U.S. economy is arguably best positioned to benefit from the artificial intelligence revolution. In turn, U.S. stocks (especially large-cap stocks in the S&P 500) may continue to outperform emerging market equities in the coming years.

Here's the bottom line: I think State Street makes good arguments for owning small-cap and emerging market funds, but I would still prioritize an S&P 500 index fund (or U.S. large-cap stocks) over those options. The S&P 500 offers exposure to the most consequential companies in the world, which makes it a very compelling long-term investment.

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Trevor Jennewine has positions in Vanguard S&P 500 ETF. The Motley Fool has positions in and recommends FactSet Research Systems, Taiwan Semiconductor Manufacturing, Tencent, Vanguard S&P 500 ETF, and Viavi Solutions. The Motley Fool recommends Alibaba Group. The Motley Fool has a disclosure policy.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.