What is an index fund?
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An index fund is a type of mutual fund that’s designed to passively track a specific stock market index. This article explains why you should invest in index funds, and where to find the best index funds in Canada.
If you’re a savvy investor, you’ve undoubtedly heard of “index funds.” But what the heck is an index fund and why would you want one in your portfolio? We answer all your burning questions about index funds in Canada.
What is an index fund?
An index fund is a type of mutual fund that’s designed to passively track a specific stock market index, such as the S&P/TSX Composite Index (the benchmark Canadian index) or the S&P 500 Index in the United States. Index funds allow investors to mimic the performance of one or more of these indices – typically at a much lower cost than an actively managed mutual fund.
Index funds are well suited for individual investors who don’t have the time, skill, or patience to analyze and manage a portfolio of individual stocks or actively managed mutual funds. Furthermore, because of the relatively low cost and broad diversification that index funds offer, passive investors can typically outperform active investors over the long term.
How an index fund works
Index investing is often referred to as “passive investing”. It’s passive because rather than having a fund manager exercising his or her own judgement to determine which stocks to buy or which methodology to follow, the fund manager simply creates a portfolio with holdings that mirror the stocks or bonds of a particular index. The idea is to hold every security in the benchmark index and then match its performance.
Passive investors don’t try to “beat the market.” Instead, they create a portfolio of index funds that try to mirror the market – specifically, by buying stocks of every company listed on an index, with the goal of matching the overall performance of the entire index. Such a strategy can help balance the risk in an investor’s portfolio, as market ups and downs will be less tumultuous across an index compared to individual stocks.
Brief history of index funds
Vanguard founder John Bogle, also known as the father of index investing, started the first index fund in 1975. This fund, now known as the Vanguard 500 Index Fund, tracks the S&P 500 and has grown its net assets to $492.2 billion (July 31, 2019). Today, index funds make up half of U.S. stock fund assets.
Index funds have grown in popularity since John Bogle made them famous. Now there’s an index and a corresponding index fund for practically every financial market across the globe.
I mentioned the S&P/TSX Composite Index in Canada, and the S&P 500 in the U.S. Other popular indexes include:
- Dow Jones Industrial Average (DJIA) tracks the 30 largest U.S. firms.
- Nasdaq Composite tracks more than 3,000 technology-related companies.
- CRSP US Total Market Index representing large-, mid-, small- and micro-capitalization stocks in the U.S.
- MSCI EAFE consisting of foreign stocks from Europe, Australasia, and the Far East
- Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index following the broad Canadian bond market
There are also many subsets of these indexes. For instance, an index fund tracking the Nasdaq-100 would invest in the 100 largest foreign and domestic companies listed on the Nasdaq Composite Index.
Indexes may use one of two strategies to construct the index. One method is called cap weighting, which takes a company’s market price and the number of outstanding shares to determine the percentage weighting of that company in the index. The larger the company, the larger the weighting in the index. The second method is called equal weighting, and with this strategy, every company, regardless of its size, will be represented equally in the index.
The index may “rebalance” once per quarter to reflect movements in the market (share price appreciation or declines). It also may ‘reconstitute’ its index once a year, meaning it drops certain companies that no longer meet certain criteria, or adds new companies that now meet the criteria.
What that means for index funds that track these market indexes is they will also need to rebalance and reconstitute along with the index to continue matching its performance and minimize tracking errors.
Index fund facts
- An index fund is a portfolio of securities designed to mirror the make-up and performance of a particular stock or bond market index.
- Index funds typically have lower MERs than actively managed mutual funds.
- Index investing is often referred to as passive investing.
- Index funds are designed to deliver market returns, minus a small fee.
- Index funds should outperform actively managed funds over the long term due to lower fees and broader diversification.
- Index funds help balance risk in an investor’s portfolio.
Index funds vs. actively managed funds
While actively managed mutual funds attempt to outperform their benchmark by picking winning stocks and timing their investments, passively managed index funds sit back and let the market do its thing. The three main principles are:
Markets rise over time (the stock market is up more than it’s down)
It’s nearly impossible to predict which stocks will outperform
Fees eat into investor returns, so it’s best to keep them as low as possible.
Index funds in Canada have lower fees
Active fund managers need to pay for their research, analytics, fund managers, marketing, and an army of advisors to sell them in the distribution channel. Canada, in particular, has a problem with fees. The latest research from Morningstar’s sixth Global Investor Experience Study gave Canadian investors a “below average” grade for fee experience. It showed that the average MER for an actively managed equity mutual fund was 2.28%.
A lot goes into a fund’s expense ratio, including operating expenses, marketing, transaction fees, and accounting. More importantly, Canadian investors typically pay a 1% embedded trailing commission for equity funds and 0.50% for fixed-income funds.
Index funds, on the other hand, have little overhead compared to their actively managed counterparts. There’s no need for research and analysis, since they’re just replicating an existing market index. They incur fewer transactions and trading costs since they’re not timing the market and moving in and out of securities.
The result is that index funds typically cost one-third to one-half the cost of an actively managed mutual fund. That’s more money in the pockets of investors each and every year.
Think of fees as the ultimate investing handicap. If a stock market index returns 8%, an investor tracking that index will see returns very close to 8% (the market return, minus its fee). An actively managed fund that charges 2.28% needs to outperform the market by 2% to make up for its higher fee.
Looking for more proof that low fees lead to higher returns? I looked at Canada’s big five banks and compared their expensive, actively managed Canadian equity funds to their low-cost Canadian index funds to see how they performed. Here are the results from August 2009 – to August 2019:
As you can see, in every case, the lower-cost index fund outperformed the higher-fee actively managed fund over a 10-year period. This aligns with Morningstar research which suggests that fees are the best predictor of future fund performance – namely, funds with lower fees will typically outperform higher-fee funds.
Active fund managers like to argue that index investors are settling for “average” returns. Why settle for average when you can invest in a mutual fund that will attempt to beat the market?
The academic research is clear, however, that very few fund managers can consistently beat the market over the long term. In hindsight, it’s easy to look back and find a few funds that outperformed for three, five, or even 10-year periods. The challenge for investors is to identify these outperformers in advance – an impossible task. What often ends up happening is a reversion to the mean, where yesterday’s winners become tomorrow’s losers.
Index investors don’t settle for average returns. Instead, they receive market returns. There’s a big difference. The majority (64.49%) of large-cap mutual funds lagged the S&P 500 in 2018. After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.
Which index funds should I choose?
If you’re the type of investor who is currently investing in your bank’s actively managed mutual funds but doesn’t have the time or inclination to manage your own portfolio or go with a robo advisor, our advice is to insist that your bank advisor build you a portfolio of index funds.
TD offers the cheapest set of index funds through its popular e-Series funds. Clients of TD can build a diversified portfolio with just four TD e-Series funds:
If you’re not a TD customer, then any of the other big bank index funds can also do the trick. All of them offer a suite of index funds to mimic the Canadian, U.S., International, and Bond markets. All are better options (as you can see in the comparison chart) than their expensive and actively managed counterparts.
Index funds vs. Index ETF
Index funds are mutual funds that track specific market indexes, such as the S&P 500 or S&P/TSX Composite Index. They’re bought and sold in units at prices set at the end of trading days. An ETF is bought and sold on an exchange just like a stock during normal trading hours. ETFs can be passive or actively managed, with many tracking the same indexes as index funds.
The best place to buy index ETFs is at a discount brokerage. Also known as an “online broker,” it’s a great option for DIY investors who feel confident building their own portfolio and don’t want to pay the high fees attached to actively managed funds. Our top choice is Questrade. With no annual fees or fees for purchasing ETFs, you can essentially build an ETF portfolio for $0, making Questrade one of the lowest-cost options out there. Use a screener to find all the index mutual funds and ETFs that are available to you through your favourite platform.
If the DIY route is intimidating and you’re not ready to pick stocks yet, you can invest in stocks with the help of a robo advisor. Robo-advisors will automatically create a diversified, balanced portfolio based on your individual preferences, like time horizon and risk tolerance. Plus, they offer fees much lower than a bank or brokerage — saving you even more money in the long run. If you want to compare robo advisors in Canada head-to-head, read our Complete guide to the best robo-advisors in Canada. But here’s the short story: with its low fees, easy-to-use platform, and exceptional customer service, Wealthsimple is our top choice for the best robo-advisor in Canada.Get started with Wealthsimple Invest
ETFs in Canada typically charge a fraction of what mutual funds cost – and so although index mutual funds are cheaper than actively managed funds, an index-tracking ETF is even cheaper. For example, Vanguard’s FTSE Canada All Cap Index ETF (VCN), which tracks the entire Canadian market, has an MER of just 0.06%. Here’s a model portfolio you can use to emulate the Canadian Couch Potato strategy – taking a balanced approach to allocation with 40% bonds and 60% stocks:
Alternatively, you can build an even simpler version of the above portfolio with just one ETF. Vanguard, along with other ETF providers such as iShares and BMO, has introduced something called asset allocation ETFs. These products are essentially balanced ETFs, with a blend of domestic and international stocks and bonds.
Vanguard’s VBAL is a balanced ETF with a 40% allocation to bonds and a 60% allocation to stocks:
RELATED: The best ETFs in Canada for young Canadian investors
Index investing amid the COVID-19 crisis
One knock against passive investing is that, while it’s great to match the market’s performance during a bull market, it’s not as fun to watch your portfolio drop when the outlook turns bearish. Indeed, index investors like me have seen their portfolios take a 20-25% hit in a relatively short one-month period during the COVID-19 crisis.
This is why investing with an appropriate asset mix is so important for index investors. My portfolio consists of one ETF – Vanguard’s 100% global equity ETF called VEQT. Year-to-date it’s down 20.93% (as of April 3, 2020).
Let’s compare that to someone who invested in Vanguard’s VBAL, which represents the more traditional 60/40 balanced portfolio. VBAL is only down 13.28% as of April 3, 2020. It’s held up remarkably well during this period of extreme volatility.
Active investors might prefer an ETF like Vanguard’s VDY – which represents high dividend yield stocks in Canada – since dividend stocks tend to be wide-moat blue-chip companies that can weather a downturn better than most other businesses. That hasn’t been the case so far this year. VDY is down 22.95% year-to-date.
Don’t let today’s turbulent market dissuade you from starting your ETF investing journey. My advice is to think long and hard about your risk tolerance and the type of losses you’d be willing to accept. Find an asset mix that matches your risk profile, and then build your portfolio with an asset allocation ETF, or 3-4 ETFs that you can maintain and stick with over the long term. You’ve got this!
RELATED: Stock market crash: The right time to buy stocks or should you weather out the Coronavirus storm?
Investors are flocking to index funds for good reason. They offer broad diversification at a low price point – two factors that lead to higher long-term performance. Investors can build a globally diversified portfolio with as few as one fund, or as many as 4-5 funds. They’re easy to buy and sell through a discount brokerage account online, making them a great fit for DIY investors. Check out our ultimate guide to Canada’s discount brokerages to find one that best suits your needs. But here’s a spoiler alert: our top choice is Questrade.