Any way you look at it, the S&P500 (^GSPC -1.32%) is absolutely crushing it these days. And this is not just a post-election phenomenon. The S&P has climbed more than 50% since the start of 2023.

Is the S&P 500 Index exchange-traded funds (ETFs) investors’ best bets as the end of the year approaches? I don’t think so. Instead, I predict that a Vanguard ETF will outperform the S&P 500 over the next 12 months.

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A booming alternative to the S&P 500

Small Cap Stocks are well behind large cap stocks over the last few years. Value stocks also underperformed growth stocks. Enthusiasm about the growth of cloud services and Generative AI fueled impressive gains for large-cap stocks that have a heavy weighting in the S&P 500 index.

Unsurprisingly, the Vanguard Small Cap Value ETF (VBR -0.70%) hasn’t generated the kind of returns that several of Vanguard’s funds that own large-cap growth stocks have. However, that has changed over the past three months, with this Vanguard ETF outperforming the S&P 500.

^SPX data by Y Charts

Technically, the Vanguard Small-Cap Value ETF doesn’t only own small-cap value stocks. The median market cap of the 835 stocks in the ETF’s portfolio is $7.5 billion, well above the $2 billion market cap at the upper end of the range for small-cap stocks. However, most Vanguard ETF holdings are relatively small.

The value part of the Vanguard Small-Cap Value ETF’s name is spot on, though. The average price/earnings ratio (P/E) of stocks in the ETF portfolio is 16.1. For comparison, the S&P 500’s P/E ratio is close to 30.

Why This Vanguard ETF Could Beat the S&P 500

Valuation is one reason the Vanguard Small-Cap Value ETF could beat the S&P 500 over the next 12 months. You may have heard the term “reversion to the mean.” The idea is that when something is higher or lower than it normally is, it is likely to return to its normal level over time. The gap between the valuations of large- and small-cap stocks is much wider than it has been historically. I suspect it will shrink – revert to the mean – with smaller stocks performing significantly better than larger stocks.

However, the main factor behind the Vanguard Small-Cap Value ETF’s recent outperformance relative to the S&P 500 is the Federal Reserve’s interest rate cut. Small businesses tend to be more sensitive to interest rates than larger businesses.

Investors also anticipate changes that may occur in the future. In particular, the prospects for reduced regulations and corporate taxes are much higher now that the election is over. Small businesses often face more challenges dealing with government regulations than larger organizations. Sometimes they are also not able to manage the complexities of the tax code as well as larger businesses and bear the brunt of taxes more heavily.

The possibility that stiff prices on all imports could be more in favor of small businesses than large businesses. Small businesses tend to focus more on the U.S. domestic market than international markets. Tariffs may therefore not harm them as much as they would large companies and could protect some small businesses from foreign competition.

What could cause the prediction to fail?

While I think my prediction that the Vanguard Small-Cap Value ETF will beat the S&P 500 over the next 12 months is based on sound reasoning, I readily admit that it could fall apart. The weakest link in my case is the “reversion to the mean” argument. While I am confident that the valuation gap between small and large stocks will narrow, this may not happen significantly in the near term.

Many economists predict that widespread tariffs will lead to higher inflation. If they are right, the Fed’s rate cuts could come to a screeching halt. Worse still would be a scenario in which the Fed starts raising interest rates again to combat inflation. That would be bad news for the Vanguard Small-Cap Value ETF. However, I have a feeling that the negative effects of the tariffs will not materialize enough by November 2025 to derail my prediction.