It's high time for many index fund investors to move away from the mother of all benchmarks, the

S&P 500

.

As index funds soared in popularity during the past decade, indexing became nearly synonymous with the S&P 500. That was fine with most investors during the late 1990s, as the S&P 500 posted a five-year string of 30% average annual returns.

However, the S&P 500's performance over the past three years has been abysmal: Since March 31, 2000, the index has lost 39%, according to Lipper. And it still sports a rich trailing price-to-earnings multiple of 30.8. "Large-cap U.S. stocks are still overvalued, and investors have too much exposure to them," says Louis Stanasolovich, founder of Legend Financial Advisors.

The dreary past and outlook for the most popular benchmark has led many individuals and professionals to question the merits of indexing. But as individuals rethink their portfolios, they need to separate the

benefits of index fund investing from the continuing trouble signs on the S&P 500 as a benchmark.

"You should not own only the S&P 500 if you want to get exposure to U.S. stocks," said Larry Swedroe, director of research for Buckingham Asset Management and author of

Rational Investing in Irrational Times

.

Here's the argument for opting out of the S&P 500: The index is too concentrated in big growth companies, too richly valued and too limited in scope to be the appropriate core holding in one's portfolio.

Big Money

The S&P 500, which Standard & Poor's created in 1957, is by far the most widely used benchmark for index fund investors. Of the $364.2 billion in index funds, $196.9 billion, or 54%, is invested in S&P 500 index funds, according to Lipper. That includes the

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Vanguard 500 Index fund, which with $54.02 billion in assets is the nation's largest stock fund.

The S&P 500 first gained popularity as an index fund in the 1970s, when Burton Malkiel suggested in

A Random Walk Down Wall Street

that individuals would be better off buying the S&P 500 than giving the money to an active fund manager. Three years later, John C. Bogle's newly founded Vanguard Group offered its flagship 500 fund.

Fortuitously, the S&P 500 indexing bandwagon took hold just before the start of the greatest bull run of large-cap stocks in U.S. market history (some people argue that the very popularity of indexing helped push up the S&P 500). From 1984 to 2000, the S&P 500 returned an astonishing 16.32% a year on average -- far above the historical 7% to 10%.

The S&P 500 index funds became the most common proxy for "buying the market." In reality, however, the S&P 500 constitutes about 80% of the total market -- specifically 500 leading companies in leading industries, which works out to be overwhelmingly large companies. Small- and mid-cap stocks, which historically outperform their bigger brethren, aren't in it.

"To the extent that the U.S. market is primarily a large-cap market, the S&P 500 will meet most of the investor's needs," said Lynn Cohn, Standard & Poor's spokeswoman. "It's not designed to be a total market index."

If an investor wants an index solely for the large-cap market, the S&P 500 is an adequate choice. But it has many drawbacks, not least of which is concentration. Because the S&P 500 is market-value weighted, the index is more exposed to the largest companies. The top three companies in the S&P 500 --

Microsoft

(MSFT) - Get Report

,

General Electric

(GE) - Get Report

and

ExxonMobil

(XOM) - Get Report

-- make up almost 10% of the index. The 10 largest S&P 500 companies make up 24.7% of the index.

This concentration can wreak havoc on the S&P 500's returns if just a few big companies blow up.

For instance, in 2000 five companies --

Cisco

(CSCO) - Get Report

,

EMC

(EMC)

,

Merck

(MRK) - Get Report

,

Nortel Networks

(NT)

and

Oracle

(ORCL) - Get Report

-- accounted for nearly one-third of the S&P 500's 9.1% loss, according to research by UBS Warburg's Thomas Doerflinger. (That calculation was first brought to my attention in an article on the S&P 500 in the May 2002 issue of

Institutional Investor

.

Click here for another compelling critique of the S&P 500, for different reasons, made by Jon Markman on

TheStreet.com

last summer.)

While the S&P 500 is no longer top-heavy with tech, that doesn't mean it's no longer growth-oriented. Of the top 10 companies, only one -- ExxonMobil -- gets categorized as a value stock.

"The S&P 500 is a great way to get exposure to the large-cap portion of the market, but it is just large-cap stocks," said Gus Sauter, chief investment officer at Vanguard and manager of Vanguard 500. "We suggest investors have exposure to the entire market through a benchmark such as the Wilshire 5000."

Room at the Wilshire?

You read that correctly: The manager of the largest S&P 500 index fund signaled that S&P 500 investors might be better served in a fund pegged to the Wilshire 5000. (He also oversees the

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Vanguard Total Stock Market Index, which does indeed use the Wilshire 5000 as its benchmark.)

In fact, Sauter isn't the only index fund devotee who advocates the switch. The two pioneers of index fund investing -- Vanguard's Bogle and

Random Walk's

Malkiel -- now say the Wilshire 5000 is the way to go. "Investors should use an index that offers a broader representation of the stock market, such as the Wilshire 5000," said Burton Malkiel in a

recent interview. "Investors who only own an S&P 500 index fund don't have exposure to smaller- and medium-size companies."

The Wilshire 5000 index consists of just about every publicly traded company in the U.S. -- more than 7,000, by latest count. For investors looking for one-stop exposure to the total U.S. stock market -- small, medium and large companies -- index funds pegged to the Wilshire 5000 are a better bet than the S&P 500.

Will McClatchy, co-founder of

Indexfunds.com and author of

Index Funds: Strategies for Investing Success

, says "there ought to be a gradual secular shift from the S&P 500 to the total market over time -- in fact, the smart indexer should anticipate that and move their assets over now rather than later."

However, upon closer inspection, the Wilshire 5000 suffers from similar drawbacks as the S&P 500 -- albeit less so. Because the Wilshire 5000 is also market-value weighted, it is also heavily skewed toward the biggest U.S. companies. Even though it represents small- and mid-cap stocks, the 10 biggest companies make up just under 20% of the index, and the top 100 constitute 57%.

In other words, even though Wilshire 5000 index funds offer exposure to medium and small stocks -- about 15% -- investors are still getting what pretty much amounts to a large-cap fund. In fact, investors are getting something remarkably similar to the S&P 500: The two indices have a 98% correlation level. In other words, they move in tandem almost all of the time, according to both Wilshire and Standard & Poor's.

"There is no great diversification offered by the Wilshire 5000," said Steven Evanson, founder of Evanson Asset Management.

Nonetheless, the choice between the S&P 500 and the Wilshire 5000 is getting clearer among many index-fund adherents. "The core index fund in an investor's portfolio should be the total market," said John Spence of Indexfunds.com.

Diversify Away From Large Growth

"At minimum, investors need to get exposure to a broader index fund that tracks the Wilshire 5000, but that alone is foolish," said Larry Swedroe. The better thing to do, Swedroe said, is to get more exposure to other asset classes and less exposure to large-cap growth stocks.

"We see so many investors who think they're diversified because they own lots of stock or lots of mutual funds, but everything they own is basically U.S. large growth," Swedroe said. Swedroe urges investors to "get exposure to international, emerging markets, bonds and real estate funds. There are index funds in all of these categories."

Many leading asset-allocation experts state that large growth companies -- read: S&P 500 -- will underperform other major asset classes during the coming decade or so. Bear Stearns Asset Management forecasts that the real rate of return -- adjusting for inflation, which historically has added 2% to 3% to annual returns -- of the large-cap S&P 500 through 2022 will be 3% to 5% a year.

"The overseas markets, with the exception of international large-caps, are not cheap, but they're reasonable," Evanson said. "U.S. stocks, with the exception of small value, are well over one standard deviation above the mean," which means they are still overvalued.

Investors with long-term time horizons shouldn't jettison large-cap U.S. stocks (although there are some highly informed Cassandras, such as Evanson, who recommend doing so), but the key lesson is an oldie but goodie: Diversify. I'm willing to bet that the worst possible portfolio for the next 10 years would be the one that so many investors banked on in the 1990s: the almost exclusively U.S. large-cap growth stock portfolio. (If you want to know if you have too much U.S. large-cap in your portfolio, check out

Morningstar's excellent Portfolio X-Ray tool.

Investors, index and active fund varieties, should be thinking of getting into asset classes that aren't so closely correlated with the S&P 500 -- in other words, they don't always move in lock step, and that greatly enhances a diversified portfolio. A few classes to consider: international value, emerging markets, U.S. small-cap value, real-estate and short-term fixed income. Each of these has a variety of index funds from which to choose -- check out Indexfunds.com's picks

for a starter course.

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