Why Index Funds Are NOT the Best Answer
by Dan Wiener | April 28, 2008 7:49 am
Indexing Is a Great Business…
But It’s a Lousy Investment
Vanguard wants you to “believe” in indexing. Your faith in indexing is the cornerstone of their business. But it’s a lie. And your trust could lead you to big losses. Here are six reasons why indexing is not the best answer
Myth #1: Index funds provide complete 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 or Vanguard Total Stock Market 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 bear market whether diversification protected them then.
Is your portfolio truly diversified? Find out here[1].
Next: Myth #2 – Index funds eliminate manager risk.
Free Investing Guide: Winning With Mutual Funds[2]
Myth #2: 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.
Investing in index funds is one of seven costly mutual fund mistakes to avoid. See the complete list here[3].
Next: Myth #3 – Index funds never underperform.
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Free Investing Guide: Winning With Mutual Funds[2]
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Myth #3: 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.
So really, how much can your fund lose? Find out here[4].
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Free Investing Guide: Winning With Mutual Funds[2]
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Myth #4: 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.
Forget tax efficiency. It’s after-tax returns that count. Learn more here[5].
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Free Investing Guide: Winning With Mutual Funds[2]
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Myth #5: Index funds are cheap.
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 Capital Opportunity may cost more than Vanguard 500 Index , but it has more than earned its fee. Since inception, Capital Opportunity has doubled the index’s return — a pretty good trick for an actively managed fund
Click here for a quick 10-step plan for a profitable 2009[6].
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Free Investing Guide: Winning With Mutual Funds[2]
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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.
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Free Investing Guide: Winning With Mutual Funds[2]
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The Numbers Don’t Lie!
Compared to actively managed funds, Vanguard’s index funds have performed miserably. Let’s use the 500 Index — an old Vanguard favorite — as our benchmark.
In 2008, the 500 Index was still beaten by a host of actively managed funds at Vanguard. Take a look:
2008 Return: 500 Index -37.0% Dividend Growth -25.6% Wellington -22.3% PRIMECAP 32.4% And this is no short-term story:
5-Year Average Annual Returns: 500 Index -0.22% Dividend Growth 3.11% Wellington 4.75% PRIMECAP 4.14% The numbers say it loud and clear — indexing is not the best answer. Even though two of the three funds that bested the 500 Index are now closed, you can still buy the best-of-the-best funds set to stomp the 500 Index in the next 12 months. It’s all spelled out in your Action Plan for Vanguard Investors[7].
Free Investing Guide: Winning With Mutual Funds[2]
500 Index: One of Vanguard’s Riskiest Funds
Vanguard has a few index funds that might fit into some portfolios, but 500 Index is not one of them. The problem? It’s one of Vanguard’s riskiest funds!
Vanguard will never ever tell you this, but 95% of the 500 Index can go up, and you can still lose money.
Surprised? Here’s a simple, yet shocking example. Say…
- The smallest 100 stocks go up a robust 25%.
- The 4th 100 largest go up 20%.
- The 3rd 100 largest go up 15%.
- The 2nd 100 largest go up 10%.
- The next 50 largest go up 5%.
- But the 50 largest stocks go down 10%.
What do you suppose would happen to your 500 Index money?
Feeling good about the answer? Sorry to say, you’d be shocked silly. Even though 95% of the Index 500 stocks went up nicely, you’d still lose 1.8% of your money.
And if all but the 50 largest stocks continue to gain over the next 15 years, you’d continue to lose money the whole time.
That’s not how you build wealth. That’s not going to help anyone’s retirement. And that’s not what you had in mind when you invested in the 500 Index, is it?
Well, the same strategy and consequence holds true for most index funds. No surprise, but this year could be the worst for index funds. If you’re looking for capital appreciation and you’re indexing to get it, you could be on your way to losing a big chunk in profits.
Get details on 7 more risky Vanguard funds to avoid here[8].
Next: Get the Vanguard 94% Advantage
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Get the Vanguard 94% Advantage
Index funds are, once again this year, set to dive. Investments that made sense as little as a few months ago are now taboo profit pitfalls. Most index funds are flooded with high-risk growth stocks.
You’ve got barrels of banks. You’ve got tons of tech. You’ve got no say in the matter.
You own unacceptably high P/E stocks that are hyper-sensitive to interest rates. This is not where you want your money these days.
I’m not saying it’s a bad idea to invest in the 500 largest stocks. What I am saying is that, if you like large caps, invest in only the best large caps…the ones that are actually making money.
- Is your portfolio truly diversified? Find out here: https://investorplace.com/video/mutual-funds/index.html
- Free Investing Guide: Winning With Mutual Funds: /order/?sid=UF3106
- See the complete list here: https://investorplace.com/experts/dan_wiener/articles/gallery/7-mutual-fund-mistakes-to-avoid.html
- So really, how much can your fund lose? Find out here: https://investorplace.com/experts/dan_wiener/articles/mutual-fund-losses.html
- Learn more here: https://investorplace.com/video/mutual-funds/video4.html
- Click here for a quick 10-step plan for a profitable 2009: https://investorplace.com/experts/dan_wiener/articles/vanguard-mutual-funds-profitable-2009.html
- It’s all spelled out in your Action Plan for Vanguard Investors: https://investorplace.com/order/?sid=KF3109
- Get details on 7 more risky Vanguard funds to avoid here: https://investorplace.com/experts/dan_wiener/articles/gallery/vanguard-mutual-funds-to-sell.html
Source URL: https://investorplace.com/2008/04/mutual-fund-indexing-active-management/