Think about the implications. If the S&P 500 Index produces 2-4% less annually than alternative measures of the U.S. equity market over the next decade or so, then: 1) billions of dollars in potential returns are going down the drain; 2) active money managers may not be achieving relative performance as high as they claim; and 3) paying attention to benchmarks used by structured products (such as Equity Indexed Annuities) could significantly increase your clients' benefits.

A Dull Average Investor

The S&P 500 Index traces its roots back to an index created in 1913 by Alfred Cowles, a pioneer of stock market charting and statistics. Although it came into existence 29 years after the original Dow Jones Index, the S&P 500 has far eclipsed the Dow Jones Industrial Average as a popular core U.S. equity benchmark, especially among professional money managers and institutions.

But for almost a century, the S&P 500 has maintained the same goal that Cowles originally assigned it – "to portray the average experience" of U.S. stock market investors. Today, with advances in financial theory and technologies, it is possible to develop indexes that reflect the U.S. stock market with a performance edge – in effect, the experience of an intelligent average investor.

In three specific ways, the S&P has come to portray the experience of a duller average investor: 1) market-cap weighting; 2) stock inclusion and turnover; and 3) component valuation premium.

Market-cap Weighting

The S&P 500 is market cap-weighted – as are other leading U.S. equity core benchmarks such as the Russell 1000, Russell 3000 and Dow Jones Wilshire 5000. Each component stock has an index weight that reflects its market cap. This means that about 50 top stocks (of 500 components) account for half the S&P's performance. The top 10 stocks, all giant companies, account for about 20% of index weight and performance.

Source: Standard & Poor's

Most financial advisors know that the S&P 500 tilts toward giant companies and thus will under-perform broader benchmarks when mid-cap and small-cap stocks excel, such as during the past five years. Many advisors expect the S&P 500 to perform better when large-caps swing back in favor.

However, it is possible that the U.S. economy has entered a long-term phase in which huge company size may be a detriment. For example, Wal-Mart has become a target of any number of boycotts and lawsuits, primarily because it is such a dominant force in retailing. Microsoft costly anti-trust problems are a direct result of its size and market clout. The next vastly profitable miracle drugs – those that will prevent AIDS and cure Alzheimer's – are more likely to be developed by smaller and more nimble companies than Johnson & Johnson or Pfizer.

A clear alternative to a cap-weight benchmark is an index such as the Standard & Poor's 500 Equal-Weight Index. Instead of tilting toward the largest companies, this index assigns the same weighting (.2%) to all 500 components, with quarterly rebalancing. In recent years, it has outperformed the S&P 500 as shown in the graph below.

Hypothetical $1,000 Invested in the S&P 500 and S&P 500 Equal Weight Indexes 1990-2005

An equal-weight index tends to perform better than a cap-weight index in market environments that favor mid-cap and large-cap stocks. But as the graph shows, the equal-weight index also has an advantage of avoiding excessive valuations based on market momentum. In the S&P 500, stocks keep receiving more index weight as they rise in value. In a strong bull market (such as the late 1990s) the index gradually acquires a higher P/E ratio than the same components have on an equal-weight basis. This can lead to over-valuation and vulnerability to corrections, as occurred in 2000-2002. An equal-weight index rebalances away valuation premium created by market momentum, so it tends to be a more value-conscious, conservative choice.

One of the most astounding statistics in today's market is the comparison between five-year performance for virtually all U.S. stocks on a cap-weight and equal-weight basis:

For confirmation and details, see:

• http://www.wilshire.com/Indexes/calculator

In both indexes compared above, components are the 5,400 largest stocks in the U.S. market, which collectively account for more than 99% all U.S. publicly-traded equities. Part of the huge performance difference is due to a cyclical swing against giant-cap companies. On the other hand, another part may be driven by non-cyclical factors, signaling a long-term trend that will make equal-weight indexes more valuable benchmarks in the future.

Stock Inclusion and Turnover

Unlike Russell and Dow Jones Wilshire indexes, in which components are selected mechanically based on "quant" statistics, the S&P 500 is driven by a committee approach to stock inclusion and turnover. The S&P 500 is like many exclusive social clubs ? it's hard to qualify for membership and equally hard to get kicked out. When companies rise and fall like meteors, they can be included in the S&P 500 near their apex and deleted just as they crash to earth.

For example, the alternative energy company Calpine was added to the S&P 500 Index on November 30, 2000, soon after it had achieved a split-adjusted price of $50+ and a market cap of about $3 billion. Amid operating losses, cash flow problems, and management turmoil (none of which were a secret to the stock market), the stock then declined steadily over the next five years. Finally, on December 5, 2005, Calpine was deleted from the S&P 500 Index ? just five days before it was suspended from trading on the New York Stock Exchange. On the day Calpine exited the S&P 500, its stock closed at 24 cents per share.This is just one example of crashing companies that the S&P 500 Index has held most of the way down. Others have included Delphi (deleted 10/10/05), HealthSouth (3/20/03), Nortel Networks (7/19/02), and Global Crossing (10/9/01).

In general, component turnover helps to keep indexes refreshed and healthy. Yet, the S&P 500 has far lower turnover than most other core U.S. equity benchmarks. For example, over the past 10 years, the Russell 3000′s quant-driven annual reconstitution process has changed an average of about 450 components per year, representing a 15% turnover rate. Over the same stretch, the S&P 500 has averaged about 5% annual turnover. In the past, higher turnover rates generated tax consequences for taxable investors in index mutual funds. But with the emergence of tax-efficient exchange-traded funds (ETFs) that track indexes, high turnover has not created tax problems.

Component Valuation Premium

When a stock is added to the S&P 500, it is estimated that indexers purchase about 10% of its total shares, on average, resulting in a sharp increase in demand and price. Recent studies have estimated that in the month or so before a stock is included in the index, its price can increase 5-10% above the expected return for the market environment, due to speculation over index inclusion. In effect, speculators beat indexers to the most likely new candidates for S&P 500 inclusion. Over many months, such speculation has added to the valuation premium of Google, America's most visible stock not included in the S&P 500.

Typically, index funds and ETFs that track the S&P 500 are among the last investors to add new index components, so they pay a full valuation premium. This premium may continue to inflate prices of index components as long as cash flow into S&P 500 indexed instruments stays strong. However, if the S&P 500 starts to lose cachet as a core benchmark, the result could be a period of negative cash flows and vanishing valuation premiums, which could drag down the index's returns for years.

While the S&P has a greater valuation premium than most competitive indexes, one articulate voice has argued that virtually all traditional index funds are at a competitive disadvantage, because they must buy new components after speculators have jacked up prices. The voice belongs to ETF guru and author Gary Gastineau, who has touted the advantages of a "Silent Index." He has defined this concept as "an index designed specifically for a single index fund, almost certainly an ETF, which would not announce changes in the index until after the fund had an opportunity to modify its portfolio to reflect the new index structure." As you will see, this concept may be nearing reality with the introduction of dynamic new indexes representing the core of the U.S. equity market.

Selecting a New U.S. Equity Core for Your Clients

The discussion that follows focuses on four promising alternatives to the S&P 500 Index as a new benchmark for U.S. equity core holdings. To summarize characteristics that can be advantageous, these ideas offer: 1) less concentration in giant companies; 2) broader inclusion of more stocks; 3) more frequent "refreshing" of index components to keep pace with dynamic markets; and 4) less speculation-driven valuation premiums (i.e., Silent Index characteristics). In each case, I have identified a way to invest in these alternatives via tax-efficient, cost-efficient ETFs.

1. The Obvious Alternative - Combine a broadly-based cap-weighted benchmark such as the Russell 1000 with the S&P 500 Equal Weight Index.

   Example:

   • 50% Russell 1000 Index via iShares Russell 1000 (IVV)
   • 50% S&P 500 Equal Weight Indexvia Rydex Equal Weight 500 (RSP)
2. The Not-So Obvious Alternative - Combine a broadly-based cap-weighted benchmark with the S&P Completion Index. This index covers most of the 5,000 largest U.S. stocks that are not included in the S&P 500 Index. It selects and weights index components according to a set of rules.

   Example:

   • 50% Dow Jones Wilshire Large Cap Index via streetTracks Dow Jones Wilshire Large Cap (ELR)
   • 50% S&P Completion Index via Vanguard Extended Market VIPERS (VXF)
3. A Rules-Based Alternative

   The relatively new FTSE RAFI 1000 Index is part of a new series or benchmarks launched in 2005 by FTSE Group in partnership with Research Affiliates. It selects and weights the largest 1,000 U.S. stocks based on fundamental data driven by a transparent set of rules. The data that drives the rules-based model includes sales, cash flow, book value and dividends. Thus, it accords more weight to companies that are big in terms of balance sheets and income statements – not market value. Based on back-testing, FTSE has demonstrated that the index would have outperformed the S&P 500 by more than 8% per year for the five-year period ending 9/30/05. One interesting side benefit of this index is its "Silent Index" characteristics. FTSE Group publishes the comprehensive rules that drive its annual component selections, and they can be accessed at:

http://www.ftse.com/Indices/FTSE_RAFI_Index_Series/index.jsp

For an index fund or ETF that studies these rules and then models the same universe of stocks, it may be possible to select and purchase components before they are announced to the world. In any case, this index does not yet have enough of an investor following to generate much component valuation premium.

• 100% FTSE RAFI 1000 Index via PowerShares FTSE RAFI US 1000 Portfolio (PRF)

Conclusion

Indexing has become the "new frontier" of the investment world, with attractive new indexes and paired ETFs introduced every month. Financial advisers who stay abreast of trends in indexing and ETFs will develop a competitive edge in capturing big-ticket assets.

You can bet that over the next 10 years, hundreds of billions of dollars will be indexed or tracked against innovative U.S. core equity indexes, including those mentioned in this article. It's also a good bet that many of those alternatives will outperform the S&P 500 over time, even if large-cap stocks cycle back into favor.

Perhaps the time has come to put less focus on the S&P 500 Index. Your clients deserve to have their investments indexed against, tracked with, or compared to U.S. equity core indexes capable of delivering performance, in addition to mirroring average stock market performance. Remember: There's dull average and smart average.

Help your clients be the smartest investors on the block.