Let’s talk about indexing versus active management.

Lots of people say that index funds are the only investment you need. At Vanguard it’s become dogma even though the company also offers some terrific actively managed funds. Index diehards say they can prove their case because index funds:

1. Provide complete diversification.
2. Eliminate manager risk.
3. Never underperform.
4. Are tax-efficient.
5. Are cheap.
6. Don’t encourage performance-chasing.

But I’ve made a career of showing that index funds are not the investment panacea that many suggest. In fact, my Model Portfolios have handily outperformed Vanguard’s flagship 500 Index fund, while taking on less risk, to boot. How?

Let’s examine each of the index-proponents’ points.

1. First, people claim that index funds provide diversification.

Fair enough. If I own 5,000 stocks, that’s pretty darned diversified, in one sense. But market-tracking indexes like the ones used as the basis for Vanguard 500 Index (VFINX) or Vanguard Total Stock Market (VTSMX) are overwhelmingly large-cap, with 70% of their market weight represented by less than 10% of the stocks in the index. And the overwhelming majority of returns will come from the largest companies in the index, not the best companies.

Just because you have lots of companies in a fund doesn’t mean you’re diversified. Ask any of the 500 Index shareholders who lost 45% of their money in the last bear market whether diversification protected them then.

2. Then there’s the claim that index funds eliminate manager risk.

Whether it’s bonds or stocks, there is no such thing as an index fund that holds the entire market. It’s impossible.

So who decides what goes in the fund? You guessed it: Managers. In 2002, Vanguard’s bond index managers were trying to make up a bit for their expense-ratio headwind and instead got caught with an overweight in some horrific bonds. They missed their index bogey by a country mile.

Two of the best-known indexes in the world…

…the Dow Jones Industrial Average and the S&P 500, are composed of stocks picked by hand! You can't tell me index funds don’t have manager risk.

3. And it gets worse. People think that index funds never underperform.

They couldn’t be more wrong! Index funds have costs. Even a fund that replicates an index exactly will only give you the index’s return MINUS the fund’s costs.

Because of costs, index funds will always underperform, and they will never outperform. Vanguard may be the best indexer in the world, and once in a while they diverge from their benchmarks to make up for their expense ratios. But in the end they still underperform.

If an index fund were to outperform its index, then, well, it wouldn’t be an index fund.

4. Of course, many index proponents will tell you that index funds are tax-efficient.

The fact is, it’s not taxes that matter, it’s after-tax returns. That is, what you keep after you pay all your taxes. Some index funds are quite tax efficient, and others aren’t. But there are plenty of actively managed funds that may be less tax-efficient than an index but still provide higher after-tax returns.

I should note that even the tax experts at Vanguard are beginning to change their tune, talking more about after-tax returns than strictly about tax efficiency.

5. It is entirely true that index funds are cheap to run.

However, low costs benefit active fund shareholders as well. You just have to pick low-cost funds. Just like with tax efficiency, what matters isn’t necessarily which fund has the lowest expense ratio, but how much money you end up with.

For example, Vanguard Global Equity may cost more than Vanguard Total International or Total Stock Market, but it has more than earned its fee.

But here comes the worst misconception about index funds:

6. 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.

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