On May 3 the S&P 500 broke 1,500, a level not reached since September 2000. Though this index is still the most widely used gauge of “the market” it has greatly underestimated the performance of the overall U.S. stock market in recent years. It has also failed to keep pace with the U.S. economy, which grew (in nominal terms) by roughly 38 percent during that period.

Among the passive investing set, conventional wisdom had long held that investors who maintained exposure to the S&P 500 would be assured of beating the majority of actively managed funds, and also of capturing a healthy share of U.S. economic prosperity because they would be effectively “buying the market.” To enjoy the fruits of capitalism, it was thought, one needed only to maintain lowcost exposure to the capital markets through a low cost market-cap-weighted S&P index fund such as the Vanguard 500. On its face it appeared adequate for the task, after all, its 500 firms have consistently accounted for over 70 percent of the entire market capitalization of all U.S. stocks.

Though the returns on the S&P 500 remain far superior to the vast majority of actively managed equity funds, the returns have failed to keep pace with the broad U.S. equity market since it last peaked in the fall of 2000. The chart below demonstrates that the overall market, as measured by the Wilshire 5000 index, has had a much better run. With dividends reinvested, $1.00 invested in the S&P 500 would have grown to only $1.09 through the end of April 2007, while the same investment in the Wilshire 5000 would have grown to $1.16.

The 4,500-odd stocks that are in the Wilshire 5000 but are excluded from the S&P 500 are categorized as “mid-caps” or “small caps,” but these categories are defined inconsistently and somewhat arbitrarily (often by marketers rather than economists). Our concern is with risk and return only. Our empirical research suggests that the small cap and micro cap investment vehicles on page 40 are very good representations of true asset classes. While both small cap and micro caps greatly outperformed large caps, micro caps have stolen the show since September 2000, with $1 growing to $2.11.

Large caps will again have their day in the sun, and small caps will take their lumps. But when that era will begin and end is anyone’s guess. Investors should have exposure to both large and small cap stocks; the higher one’s tolerance for risk and longer one’s time horizon, the more one can afford exposure to the more volatile small caps.

Also In This Issue

Investing And The Business Cycle
Mutual Fund Securities Lending: Hidden Risk And Return
The Executioner Of Excellence
The High-Yield Dow Investment Strategy
The Dow Jones Industrials Ranked By Yield
Recent Market Statistics