Why Index Funds Are NOT the Best Answer

Myth #6: Index funds don’t encourage performance-chasing.

This is quite possibly the worst misconception about index funds. Contrary to popular belief, rather than discourage performance-chasing, index funds actually ENCOURAGE it.

For example, a few of years ago, I was amused to read on Morningstar.com a list of “The 10 Biggest Wealth-Creating Funds of 2004,” one of which was Vanguard’s 500 Index fund. Morningstar said: “One of the great things about index funds like this one is that they’re so diversified that people rarely panic and sell. Thus, they stick around for rallies like we’ve seen the last two years.”

But that’s simply not true. In 1998, the last time the S&P 500 was really leading the performance parade, as returns were rising, so were inflows to Vanguard’s 500 Index fund, with more than 1.5 billion dollars flowing in each month. As returns waned, so did cash inflows. So, as you can see, index investors have been notorious performance-chasers.

So when I look for the best funds available at Vanguard, I don’t look for the lowest expenses or the broadest diversification. I look for funds that provide the best returns once you’ve paid your dues — whether that’s expense ratios, fees, or taxes.

Next: The numbers don’t lie!