Index funds are a low-cost option for new investors to commence their investing journey while earning “market returns” and saving on “investment fees.”
The use of low-cost index funds can also prepare and boost the confidence of beginners for more DIY-type investing with ETFs and other individual investment assets.
Index Funds vs. Mutual Funds
It is easy to get confused by what an index fund is vs. a mutual fund. To put it simply, an index fund is a type of mutual fund designed to track a market benchmark or index (such as the S&P/TSX Composite or S&P 500) and to replicate its return.
For example, if an index fund is designed to track the S&P 500, it may also contain the 500 stocks that are in the S&P 500 index or use other strategies to mirror the holdings of the index. The fund will also attempt to generate the returns of the S&P 500, less any fees incurred.
Index funds are passively managed and fund managers only need to make adjustments when required due to changes to assets in the benchmark index.
Traditional mutual funds, on the other hand, are actively managed. The fund manager of a mutual fund tries to beat the benchmark index (e.g. S&P 500) and will buy and sell asset holdings with the intent to outperform the market.
Advantages of Index Funds
1. Low Cost: Fees charged by index funds are lower than the average mutual fund. This is because index fund managers utilize a passive strategy that involves less buying and selling and overall lower transaction fees. The lower fees can also translate into higher returns for investors.
2. Higher Return Potential: Unfortunately, the active management strategy by mutual funds do not always yield the expected results. Studies show that after adjusting for survivorship and other biases, 80% or so of mutual funds underperform their benchmark index every year. Essentially, you have just paid them high fees for nothing.
On the other hand, an index fund is expected to generate market returns, minus fees. For example, an index fund that is tracking the S&P 500 may return 7.10% in a year that the S&P 500 (benchmark or market index) returns 7.16%. The difference of 0.06% accounts for fees and other tracking errors.
3. Diversification: Unlike buying individual stocks, index funds can provide you with even better diversification than a mutual fund offers and at a lower cost.
Depending on the type of index funds (one-fund portfolios or individual funds), you may need to rebalance your portfolio on an annual basis to ensure your asset allocation continues to correspond with your risk tolerance and return objectives.
4. Low-Minimum Investment Requirement: Index funds (like mutual funds) are great for beginners who need a low-barrier entry into investing. You can generally open an index fund account with as low as $100 and set-up automatic contributions from your bank account for as low as $25.
5. Tax Advantage: Index funds conduct fewer buy and sell transactions than actively-managed mutual funds. This results in a lower turnover of assets, fewer capital gains distributions, and tax burden.
Update: Since writing this article, we have seen ETF providers come up with simple all-in-one ETFs you can use in your portfolio without needing to rebalance. I personally prefer this low-cost ETF options compared to traditional index funds.
That said, you should watch out for brokerage commissions when you purchase ETFs using a discount broker. If you make frequent small purchases, your fees add up and eliminate your investment fees savings.
Examples of all-in-one ETF portfolios include:
- Vanguard Growth ETF Portfolio (VGRO)
- Vanguard All-Equity ETF Portfolio (VEQT)
- Vanguard Balanced ETF Portfolio (VBAL)
- iShares Core Growth ETF (XGRO)
- iShares Core Equity ETF Portfolio (XEQT)
Examples of Index Funds in Canada
New investors can purchase index funds from all the major banks as well as some credit unions and online banks.
There are “one-fund solutions” that are already designed to suit your risk tolerance and investment objectives (such as conservative (income-focused and low-risk), balanced (low to medium risk), and growth (medium to high risk).
These funds are automatically re-balanced and require zero effort on your part. There are also no commission fees when you purchase shares/units.
Examples of one-fund solutions include:
Their fund offerings include:
- Balanced Income Fund: 70% fixed income amid 30% equities (stocks)
- Balanced Fund: 40% fixed income and 60% equities
- Balanced Growth Fund: 50% fixed income and 50% equities
- Dividend Fund: 100% dividend equities
- Equity Growth Fund: 100% equities
- The Management Expense Ratio (MER) for all Tangerine funds is 1.07%.
2. TD balanced Index Fund: 50% fixed income and 50% equities; MER is 0.89%.
3. CIBC balanced Index Fund: 40% fixed income and 60% equities; MER is 1.22%.
Individual Index Funds
You can purchase individual index funds and combine them in different proportions to make up your own diversified portfolio. The most popular in this category of funds is the TD e-Series Index Funds.
Their index fund offerings include:
- TD Canadian Index – e (TDB900): MER 0.28%
- TD Canadian Bond Index – e (TDB909): MER 0.44%
- TD U.S. Index – e (TDB902): MER 0.33%
- TD International Index – e (TDB911): MER 0.44%
A sample balanced index portfolio using TD e-Series funds is as follows:
Further Reading: A Sample TD e-Series RESP Portfolio
- RBC Canadian Bond Index Fund (RBF700): MER 0.70%
- RBC Canadian Index Fund (RBF556): MER 0.66%
- RBC U.S. Index Fund (RBF557): MER 0.66%
- RBC International Index Currency Neutral Fund (RBF559): 0.61%
A sample balanced index portfolio using RBC index funds is as follows:
- Scotia Canadian Bond Index Fund (BNS186): MER 0.61%
- Scotia Canadian Index Fund (BNS181): MER 0.77%
- Scotia U.S. Index Fund (BNS182): MER 0.86%
- Scotia International Index Fund (BNS187): MER 1.03%
The Scotia index funds above belong to their Series D offerings.
Rebalancing a Portfolio of Index Funds
When you put together an investment portfolio using these individual index funds, it is important to look at your asset allocations at least once every year, for any drifts away from your preferred percentages.
Rebalancing is easy and involves buying more of an asset that is lagging in performance and/or selling some assets that have performed well.
An index fund is great for new investors who want to learn the ropes of DIY investing and lower their investment fees. You can start investing with a small amount and set up regular weekly/monthly contributions as low as $25.
When your trading confidence grows and your portfolio is larger, you can then step up your game with low-cost ETFs purchased via an online discount brokerage.
Alternatively, you can also save on investment fees and avoid the hassle of re-balancing by using a robo-advisor.