Six Months Into 2024, This Vanguard ESG Fund Trailed the S&P 500. But Don't Panic If You Own It.

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The S&P 500 Index’s performance has been driven by a small number of big companies. The Vanguard ESG U.S. Stock ETF is more diversified.

If there’s one thing you can count on when investing, it’s that markets will vary — sometimes by a little and sometimes by a shocking and swift amount. In the first half of 2024, the stock market rallied strongly, with the S&P 500 gaining 14.5%.

However, some investors might have wanted an exchange-traded fund focused on environmental, social, and governance (ESG) issues as an alternative to the S&P. And so they bought the Vanguard ESG U.S. Stock ETF (ESGV 0.67%). For these investors, their gain in the first half of the year was a little shy of the S&P — roughly 13.5%. If you were one of them, here’s why you shouldn’t worry about the Vanguard ESG fund’s laggard performance.

Six months is not a long time

Theory tells the world that investors are rational, but anybody who has put their money on the line knows this isn’t completely true. Over short periods of time, Wall Street can do some pretty illogical and shocking things.

It is over the long term that investors tend to get things correct. Which is the No. 1 reason that six months of performance shouldn’t worry you. In fact, even a year or two probably isn’t long enough to start worrying when you are looking at a large and diversified exchange-traded fund (ETF) like the Vanguard ESG U.S. Stock ETF.

ESGV data by YCharts.

In the grand scheme of things, a percentage-point difference in performance over half a year just isn’t that big a deal. The Vanguard ESG fund was up a lot, too, so it really had a good first half. Just not as good as the S&P 500 index.

Meanwhile, if you go back to the inception of the ETF, it has actually managed to outperform the S&P 500 by a few percentage points. So, despite the near-term shortfall, it remains a very good proxy for U.S. stocks. And it provides socially conscious investors with a way to put their money where their beliefs are on the ESG front. That’s a powerful combination.

ESGV data by YCharts.

Part of the problem right now, and the big reason for the Vanguard ESG fund’s strong performance over the longer term, is its diversification. The S&P 500 owns roughly 500 stocks; the Vanguard ETF owns 1,431. While both are market-cap-weighted, there are implications to holding so many more securities.

One sector to rule them all!

There are two more ETFs that help highlight what is happening right now: the Invesco S&P 500 Equal Weight ETF (RSP -0.04%) and the Technology Select Sector SPDR ETF (XLK 0.31%). Taking the easy one first, the Technology Select ETF did even better than the S&P 500, which highlights the fact that the sector was an important part of the broader index’s performance — the tech sector makes up a third of the S&P 500.

SPY data by YCharts.

If you watch the markets, you know the big names, which include Nvidia, Microsoft, Apple, Amazon, and Meta Platforms. These are the top five stocks in the S&P 500, and all but one outperformed the broader index, some by a shocking margin.

But there’s more here than meets the eye. Because the index is market-cap weighted, these stocks had a disproportionate — and positive — impact on the S&P 500’s return in the first half.

SPY data by YCharts.

You know that because the Invesco S&P 500 Equal Weight ETF underperformed by such a wide margin, trailing the market-cap weighted S&P 500 by roughly 10 percentage points. When an equal-weight approach is used, each stock in the fund affects performance to the same degree. A small number of strong performers drove the market-cap weighted S&P higher, while the rest of the index dragged down the equal-weighted version of the same portfolio.

That brings us back to the Vanguard ESG U.S. Stock ETF. It, too, is market-cap weighted and counts the very same technology stocks as its top five holdings (and the technology sector is an even larger 39% of its assets). But its portfolio is so much larger that the strength of the largest holdings gets diluted more than it does in the S&P 500, which has around 900 fewer stocks in it.

Essentially, a small number of strong stocks had to pull so many more laggard stocks along in the Vanguard ESG U.S. Stock ETF portfolio that it just couldn’t keep up with the S&P 500 index. Frankly, it’s pretty impressive that the Vanguard ESG fund still managed to do as well as it did relative to the S&P 500.

This bug is a feature of the Vanguard ESG fund

So here’s the problem right now that investors in the Vanguard ESG U.S. Stock ETF have to wrap their heads around: Its diversification is why it is a good alternative to the S&P 500 over the long term. But the ETF’s diversification is also why its performance might sometimes deviate from that of the S&P 500 index over short periods.

The best thing to do here is probably to sit tight and accept the fact that sometimes, things aren’t in perfect alignment because, over the short term, the stock market is driven by volatile emotions. Give it enough time, however, and investors will probably get the long-term story right.

John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to Meta Platforms CEO Mark Zuckerberg, is a member of The Motley Fool’s board of directors. Reuben Gregg Brewer has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Amazon, Apple, Meta Platforms, Microsoft, and Nvidia. The Motley Fool recommends the following options: long January 2026 $395 calls on Microsoft and short January 2026 $405 calls on Microsoft. The Motley Fool has a disclosure policy.