With increasing interest in DIY Investing in Canada and the maximization of investment returns by lowering fees, the term “index investing” has greatly grown in popularity.
Before digging deeper into index investing, let’s first clarify what it means and how the terminology came about.
A stock index refers to a specific portion of the broader stock market and is a measurement of the performance or value of that segment of the stock market.
For example, consider one of the world’s most popular stock indexes (or indices), the Standard & Poor’s 500 – popularly referred to as the S&P 500.
This index consists of 500 of the largest companies in the U.S. that are weighted based on their market capitalization. These 500 companies make up about 80% of the total value of the U.S. stock market.
Other examples of popular stock market indexes in the U.S. and Canada include the Dow Jones and Nasdaq (U.S.) and S&P/TSX Composite (Canada).
Others by region include:
- Latin America: S&P Latin America 40 Index
- Europe: FTSE Euro 100, Euro Stoxx 50, and S&P Europe 350 Indexes
- Asia: S&P Asia 50, Dow Jones Asian Titan 50, and FTSE ASEAN 40 Indexes
- Africa: S&P Africa 40 Index
- Global: MSCI World, S&P Global 100, S&P Global 1200, Dow Jones Global Titans 50, and FTSE All-World Indexes
Like stock indexes, bond market indexes also measure the performance or value of a section of the bond market. Examples include the FTSE TMX Canada Universe Bond and Canada All-Corporate Bond Indexes.
What is Index Investing?
As explained earlier, an index (stocks or bonds or commodities) reflects the value of a portion of the financial market. For example, if the S&P 500 is down significantly, the general idea is that the U.S. stock market is depressed during that period.
This does not mean that all stock prices are down, however, it infers that on average, a good number of companies closed the day with their stock prices in the red. Or at the very least, most of the big players had seen a significant drop in their stock price.
This broad inference is possible because the firms that make up the S&P 500 constitute about 80% of the U.S. market.
Thus, the S&P 500 index is a good benchmark for the performance or value of a major portion of the U.S. market (and other major indexes for their respective countries/regions).
What index investing does is direct your investing funds into index funds or Exchange Traded Funds (ETFs) that track one or more market indexes.
In theory, an index fund or ETF will hold a basket of stocks, bonds, commodities, or other investments that mirror a particular benchmark index whose performance you’re trying to replicate.
For example, an index fund that tracks the S&P 500 will hold stocks that mirror or are representative of the composition of the S&P 500 in an attempt to theoretically replicate the market return (i.e. the same annual return generated by the S&P 500 as a whole).
The main idea behind index investing is the achievement of market returns at a much lower cost by using passive management.
The popularity of index investing is largely due to the inability of most actively managed funds to consistently generate returns that outperform the market (index).
The central idea is that instead of trying to beat the market and paying ‘skilled’ fund managers up to 2.5% in Management Expenses (MER) to do so, you can simply buy the market itself, save on fees, and hopefully get the market return in the long term.
Investment firms create these indexes and you can buy a portion (share) of one of these indexes. Easy peasy! 😉
Or, as aptly put by one of the founding fathers of index investing, John Bogle:
Don’t look for the needle in the haystack. Just buy the haystack!
Index Investing and Sample Portfolios
There are literally hundreds (or even thousands) of options out there for DIY investing wannabe’s who want to start indexing – from simple one-fund solutions to individual index funds, and ETFs.
A. One-Fund Solutions
One-fund solutions are an easy way to get started in index investing as they provide investors with access to low-cost diversified portfolios.
The funds can be designed in a way that makes them “balanced” for the average investor (and risk tolerance). They can also be designed to meet different criteria such as retirement needs, risk tolerance, income, or growth needs.
Forget about the need to re-balance your portfolio – you can just buy into a balanced fund and the rest will take care of itself.
Examples of one-fund solutions include:
1. Tangerine Investment Funds
Tangerine Balanced Income Portfolio
- Allocation: 30% stocks and 70% bonds
- MER: 1.06%
- Risk: Low to Medium
Tangerine Balanced Portfolio
- Allocation: 60% stocks and 40% bonds
- MER: 1.06%
- Risk: Low to Medium
Tangerine Balanced Growth Portfolio
- Allocation: 75% stocks and 25% bonds
- MER: 1.05%
- Risk: Medium
Other index funds by Tangerine include:
- Tangerine Dividend Portfolio (1.06%)
- Tangerine Equity Growth Portfolio (1.06%)
You can get more details in this review of the Tangerine Investment Funds. Tangerine recently introduced Global ETF Portfolios with lower management fees.
2. TD Balanced Index Fund
- MER: 0.89%
- Risk: Low to Medium
While you’ll still pay substantial fees (compared to ETFs) in MER for these balanced funds, you’re paying much less in fees than you would for traditional mutual funds.
At an average of 1.98% MER for traditional mutual funds, the balanced index funds above make the cut and are a good starting point for index investing.
B. Individual Index Funds
These individual index funds can be purchased from most financial institutions. They are specific funds designed to track different indexes and you may need to combine several funds in your portfolio based on your desired asset allocation and risk tolerance.
The most popular and clear winner in this category is the TD e-Series Index Funds. You can view a sample RESP portfolio designed using TD e-Series Funds here.
A model balanced index fund designed using TD e-Series funds and the Couch Potato strategy is as follows:
|TD Canadian Bond Index Fund||TDB900||40%||0.44%|
|TD Canadian Index Fund||TDB900||20%||0.28%|
|TD U.S. Index Fund||TDB902||20%||0.33%|
|TD International Index Fund||TDB911||20%||0.44%|
|Average Weighted MER||0.39%|
As you can see, these index funds are much cheaper than traditional mutual funds.
There are several other individual index funds that are sold by banks and which can feature in your DIY portfolio. To make your own “balanced fund”, allocate a proportion to each fund type based on your risk tolerance, investment horizon, and objectives.
C. Exchange-Traded Funds (ETFs)
ETFs have become popular in Canada as they are now available through multiple providers and brokerages – a far cry from where we were just a couple of years ago.
The number of ETFs grew to over 7,602 in 2020, with over 7.74 trillion U.S. dollars in assets under management.
For DIY investors, there is a wide variety of index ETFs tracking different market indices in the stocks, bonds, and commodities categories.
Unlike traditional mutual funds, ETFs are traded like stocks on a stock exchange, and prices can change or fluctuate up and down all day long.
Management fees (MER) are very low for ETFs (as low as 0.03%), easily beating mutual funds hands-down. However, depending on the brokerage and type of ETF you’re buying/selling, commissions may be charged per transaction and this can drive up your transaction costs.
ETF providers in Canada include Vanguard, BMO, iShares, Horizons, RBC, First Trust, and a few others.
Similar to when you buy individual index funds, with index ETFs, you will also need to rebalance your portfolio every once in a while in order to keep your asset allocation close to your desired levels.
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A sample balanced portfolio based on the Couch Potato strategy is as follows:
|BMO Aggregate Bond Index ETF||ZAG||40%||0.14%|
|Vanguard FTSE Canada All Cap Index ETF||VCN||20%||0.06%|
|iShares Core MSCI All Country World ex Canada Index ETF||XAW||40%||0.22%|
|Average Weighted MER||0.16%|
To avoid the hassle of rebalancing, you can buy an all-in-one ETF…also referred to as “one-ticket” or “one-solution” ETFs.
An alternative way to invest in ETFs without hassle is to use the services of a robo-advisor. They offer custom low-fee ETF portfolios, automatic rebalancing, and free financial advice with a management fee of around 0.50%.
Canada’s most popular robo-advisor, Wealthsimple, offers my readers a cash bonus when they open an account and deposit at least $500.
Advantages of Index Investing
Passive: Index funds are cheaper on management fees because they are managed passively. Since a majority of active fund managers do not consistently outperform their benchmark index, passivity wins the day.
Low Cost: One reason why actively managed funds ‘manage’ to underperform index funds is because of costs. Costs to pay for supposedly superior managers and the increased costs they incur for increased transactions (buying and selling) as they try to game and beat the market.
Since fees incurred in index funds are lower, returns are often higher.
As Warren Buffet himself said,
The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of professionals.
Market Returns: If the Efficient Market Theory is to be believed, then actively trying to beat the market will not work in the long term as all information is already priced into stock prices and stock-picking is a waste of time.
Do you see why 80% or more of actively managed stock funds underperform their benchmark index every year?
Index investing is geared towards trying to make the market return which is more than many active mutual funds can boast of. To put it simply, with index investing, you’re guaranteed average returns.
Diversification: Unlike buying individual stocks, indexing provides low-cost diversification of your assets. If you have one or two stocks, your portfolio is a lot riskier than when you hold an index fund that contains all the stocks representative of the “market.”
Less Stressful: An index fund is less stressful than trying to play the market. For a portfolio you create using individual index funds, you’ll need no more than an hour or so to rebalance it every year.
If you go for a one-fund solution, you can simply seat back and let compound interest and the market work their magic.
Flexibility and Simplicity: There are index fund solutions that work for differing individual circumstances, investment timelines, funds availability, risk tolerance, and so on. You don’t have to be an investing guru to make money using index investing, or as put by Warren Buffet (again):
By periodically investing in an index fund, for example, the know-nothing investor can actually outperform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.
You may also be interested in:
- Everything You Need to Know About GICs
- Best Money Management Apps in Canada
- Online Discount Brokerage Platforms in Canada
- 10 Risks Investors Need To Understand
- The 10 Golden Rules of Investing
Resources to get you started on Index Investing:
Common Sense on Mutual Funds by John Bogle
The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein
The Little Book of Common Sense Investing by John Bogle