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It's been a rough three years for stocks, hasn't it?

Well, that's what you might think. After all, the

S&P 500

has fallen 38% from its peak in March 2000 when it briefly touched 1552. What you may not realize, however, is that slightly more than half of the stocks in the index are actually higher today than they were during the peak of the market bubble.

In fact, the equal-weighted S&P 500 index hasn't budged from where it was back in March 2000, although it is down 16% from its May 2001 high.

Weight Watchers

"People shouldn't blindly pursue a cap-weighted index," said Tom McManus, chief investment strategist at Banc of America. "That's what caused many investment strategies to go off a cliff in 2000."

In a weighted index, stocks with large market capitalizations -- like


(MSFT) - Get Microsoft Corporation Report


General Electric

(GE) - Get General Electric Company Report

-- have a bigger impact than those with smaller market caps. Because big companies are often widely owned and contribute greatly to overall earnings growth, some investors consider a weighted index to be more representative of the economy. But an equal-weighted index can give a better sense of how most stocks are performing because it isn't skewed by size.

Since the start of the year, the unweighted S&P index is up 15% compared to just 8.9% for the weighted index. And Carlos Asilis, fund manager at Vega Asset Management, thinks this trend can continue as small-cap stocks continue to outperform their larger brethren.

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He noted that small-cap valuations remain attractive and said these stocks should hold up well in a period of rising long-term interest rates.

"In terms of their indebtedness and balance-sheet fragility, I would say the large-caps are more vulnerable," he said. "Small-caps are more equity-financed than debt-financed." It's also true that over long periods of time, typically 20 years or more, small-caps have an edge over large-cap stocks.


Unlike the 1990s, when just a handful of stocks accounted for most of the gains, more stocks have risen in the past three years, said Richard Nash, chief market strategist at Victory Capital Management. He doesn't expect that to change anytime soon.

"This is the beginning of a trend," he said, adding that he is not willing to make big bets on any one sector right now.

So how can investors capitalize on this broadening market? Morningstar fund analyst Emily Hall notes that the Morgan Stanley Value Added Market Equity fund tracks the S&P 500 equal-weighted index.

On a three-year annualized basis, the fund has fallen just 0.4%. But with an expense ratio of 1.6% and a deferred load of 5%, the fund isn't cheap. Hall also said that while the fund has performed well during the bear market, it was a big loser during the bull market.

Stealth Rally

A slightly less expensive way of tracking the equal-weighted S&P 500 is through the

Rydex Exchange Traded Fund

(RSP) - Get Invesco S&P 500 Equal Weight ETF Report

, which has a management fee of 0.4%.

"People need to be aware that this is a very unusual form of indexing and doesn't work in every market," Hall said.

Still, McManus continues to advocate the equal-weighted approach. He notes that while the S&P has been in a trading range over the past six weeks, "the vast majority of stocks are rallying."

"It is easy to see the recent consolidation in the S&P 500 has been caused mostly by significant pullbacks in the energy, telecommunications services and utilities sectors," he said, adding that the pharmaceutical industry has dragged down the health care sector on a cap-weighted basis, even though the median return for health care companies is "solidly in the black, up and down the capitalization range."

Like McManus, Nash said he would be wary about mimicking the weighted S&P 500 index, saying that active fund managers could actually do better going forward. "Active management will outperform passive management over the next few years," he said.

While active managers attempt to beat the returns on the S&P 500 (or some other benchmark), passive managers seek to match the index's returns. But it's worth noting that active management has historically underperformed the passive approach. Over the past 10 years, only 28.3% of all actively managed U.S. stock funds managed to beat the S&P 500, according to fund-tracker Lipper.