What Are Index Funds?

Index funds are an appealing choice for first-time investors or those looking to passively invest their money in established markets. But just because it’s easy doesn’t mean it’s always the right choice for everyone.

What is an index fund

When it comes to investing, it’s quite likely that you’ll come across a few terms that’ll pop up over and over again. And if you’re focusing your efforts on the stock market in particular, then you’ll probably see a lot of talk about “index funds.” But what exactly are they?

Index funds are kind of like a “mini-me” of an established market index, such as S&P 500 or the Dow Jones Industrial Average. Index funds ensure that your portfolio is diversified. When you invest in an index fund your money is spread across many companies in a popular index, so all of your investing eggs are not in one basket, instead of just focusing on individual stocks. That’s where index funds come in very handy!

Index funds tend to be appealing options for investors that believe in a passive investing style, where the emphasis lies in mirroring the market instead of constantly trying to beat it. Since index funds mirror the market’s performance, you don’t need to be concerned with beating the market, or picking stocks and buying hundreds of“winners” that will outperform the market’s annual growth.

How to invest in index funds

Index funds are a relatively simple to buy, and getting started is pretty similar to investing in a mutual fund. Here’s some step-by-step instructions to get you on your way in buying your first index fund.

1. Decide what index funds to buy

Before you get started you’ll have to decide what kind of market index you want to track. Do you want to go really broad with something like the S&P 500? Maybe you want to track the market index of a particular country. That might be the S&P/TSX in Canada, the Dow Jones in the United States or the Footsie in the UK. You might focus on companies that have a high valuation (high market capitalization) or a low valuation (low market capitalization).

If you’re not sure which index fund might be best—or if you’re just a bit overwhelmed by the whole process in general—then it might be a good idea to look into a robo-advisor. While the name may sound very futuristic, it’s actually quite simple: An algorithm develops a balanced and diversified portfolio for you based on certain information you’ve provided, and even automates regular investment deposits to ensure your money keeps growing. Apart from making this whole investment thing super easy, it also ensures that you can participate in various markets by automatically investing in many index funds, and also automatically re-balancing your portfolio if the proportions in the index shift. It’s like having a financial advisor, but at a fraction of the cost.

2. Choose a broker/trading platform

You can actually purchase index funds directly from the fund issuer like Vanguard or Fidelity. This comes with a limitation — you’ll often you’ll only be able to buy their funds and nobody else’s. If you want to have options, going through an online broker is probably your easiest—and cheapest—bet. Look out for brokers offering $0 commission trading so you don't have to pay high fees to trade index funds. With 99.9% of our lives lived out online, it’s no wonder that the same goes for investing, and you can comfortably sign up for an account and buy your first index funds without even having to set down that breakfast burrito you’ve been working on! Here are some things to look out for before you signup to a broker.

Value: You’ll want to understand exactly how much you’ll be charged by any trading platform you clap your eyes upon.Though you could buy index funds over the phone from humans a discount brokerage is a much cheaper option. Most online trading platforms will assess a flat per-trade commission fee for any security purchase, big or small, that generally ranges from $0-$10 per online trade. The zero part wasn’t a typo! There are some providers that allow for commission trading. Word to the wise—fees may be higher or lower depending on your account balance and trading habits.

Features: Every trading platform has a different feature set. Some are simpler to use than others. Some allow you to check the current price of index funds or even read news about index funds you follow. Another important question you’ll want to ask yourself is beyond actually executing the trade, what other investment-related services are important to you?

Security: The most basic thing any stockbroker should offer is peace of mind to know that regardless of your investing acumen, your broker’s not going to disappear with your money. So don’t fall for any online phishing scams or too-good-to-to be true stock offers from random callers. If your broker is legit, it will almost certainly be a member of the Canadian Investment Regulatory Organization (CIRO) and you will be able to find it on CIRO’s website.

Reviews: You can also consult user-generated app reviews on the Apple App Store or Google Play Store. Or even better, find someone you know who’s using the trading platform you’re investigating.

3. Make the trade

Once you’ve decided what index funds to buy and the platform you want to trade on, it’s usually pretty intuitive from here on out When first signing up for an investment platform or an online brokerage, you have to link up your bank account to fund the investment account and be able to start investing. You pick how many shares of the fund you want to buy, and click the “buy” or “trade” button. Just like ordering that second breakfast burrito online!

4. Hold tight

We’ve emphasized the importance of long-term strategizing when it comes to index funds. If you want to start withdrawing money in five years or less, then index funds might not be for you. Think instead of a long-term goal, like retirement. Historically, big markets have provided steady returns for patient investors who don’t spend too much time fiddling about with their portfolio. After all, the average annualized total return for the S&P 500 over the past 90 years has been 9.8%! But also always remember one of the core principles of investing: past performance is no guarantee of future results!

Examples of Canadian index funds

The most famous index funds tend to be those that track big-name markets like the S&P 500 or the Dow Jones, but Canada has several significant stock market indexes of its own, and the corresponding index funds to track them.

TD Canadian Index – e (TDB900)

This fund tracks the performance of large, well-established Canadian companies. It’s a mutual fund that tracks the Solactive Canada Broad Market Index, which are comprised of assets traded on the Toronto Stock Exchange. This is also one of the largest funds.

Issuer: TD Asset Management Inc Assets Under Management (AUM): 1.275B Management Expense Ratio (MER): 0.32%

CIBC Canadian Index (CIB300)

This mutual fund uses the S&P/TSX Composite Index as its benchmark index, which contains companies traded on the Toronto Stock Exchange. Like other funds on this list, its asset allocation focuses on the financial sector, as well as on other key industrial sectors.

Issuer: Canadian Imperial Bank of Commerce Assets Under Management (AUM): 735.60M Management Expense Ratio (MER): 1.14%

RBC Canadian Index Fund (RBF556)

The fund invests primarily in equity securities of Canadian companies in order to track the performance of the S&P/TSX Capped Composite Total Return Index. Its top investments include the Royal Bank of Canada, the Canadian National Railway Co., and the Toronto-Dominion Bank.

Issuer: RBC Global Asset Management Inc. Assets Under Management (AUM): 732.14M Management Expense Ratio (MER): 0.66%

Scotia Canadian Index Fund (BNS181)

This fund invests primarily in the stocks that are included in the S&P/TSX Composite Index and aims to track that index. It also invests primarily in the financial sector, including in the Royal Bank of Canada and the Toronto-Dominion Bank.

Issuer: Scotia Asset Management Assets Under Management (AUM): 244.10M Management Expense Ratio (MER): 0.77%

Examples of low-cost index funds

While we’ve already mentioned that index funds are cheaper than traditional mutual funds due to their lower fees, there are still annual management fees you’ll have to pay, and some funds will have more fees than others, depending on what kinds of services they offer.

If you’re looking for low-cost index funds, you’ll want to keep an eye out for funds that have a low management expense ratio (MER) and skip trading commissions in particular. Low-cost index funds generally require a low minimum investment, which can be a great benefit for first-time investors just starting out. Here are a few examples of low cost index funds

S&P 500-tracking index funds

Some index funds that have low annual fees and track the S&P 500 are the Schwab S&P 500 index, which has a so-called annual expense ratio of 0.02% or the Fidelity 500 index, which also has an expense ratio of 0.02%.

International stock index funds

Some low-cost funds in this category include the Vanguard Total International Stock Index, which has an expense ratio of 0.17%, or the Schwab International Index Fund, which has an expense ratio of 0.06%.

Bond index funds

Some low-cost contenders include the Vanguard Total Bond Index and the Northern Bond Index, which both have expense ratios of 0.15%. In Canada, the Vanguard Canadian Aggregate Bond Index ETF has an expense ratio of 0.13%.

Benefits and drawbacks of index funds

Index funds can be an appealing way for first-time, busy, cautious, and budget-minded investors to get in on the investing game. But investing is not a one-size-fits-all type of thing, and index funds have certain disadvantages that you need to be aware of before you start putting money on the table.

Pros of index funds

Accessibility: Unlike certain mutual funds that require research and an expensive fund manager or financial advisor, an index fund lets you easily participate in a market of your choosing and takes away the headache that comes from having to choose what stock you think will perform best. By investing in index funds, you’re choosing a passive investment strategy that simply mirrors the market instead of constantly trying to beat it. That makes index funds an attractive choice for investors who don’t have the time, money, or energy to pay a fund manager and research specific companies.

Low costs: Especially when compared to traditional mutual funds, index funds tend to have much lower fees. No active managing means less in annual fees, and low- to no-trading commissions. So maintaining a portfolio of index funds will usually run you 0.05% to 0.25% annually, while actively managed funds can charge 1% to 2%.

Built-in diversification: For new investors uncertain about how to diversify their portfolio, index funds can be a helpful starting point. Since they reflect the proportion to which certain companies are represented in the market, it means that your portfolio is automatically drawing from various companies and various industries, especially if you’re mirroring a broad market like the S&P 500. And as you probably know, there are few things we like more than a diversified portfolio!

Cons of index funds

Low flexibility: What makes index funds so appealing to passive investors can make them frustrating for investors who want to have more control over what companies do and don’t make it into their portfolio. For an investor who’s keen to invest in a new sector like cryptocurrency, being tied to an index can feel limiting. Similarly, if there are companies in the index whose business practices you don’t agree with, there’s not much you can do about it.

Low risk, low reward: Index funds are usually considered to be rather low-risk in comparison to picking and choosing stocks that you think will beat the market. This is especially true if you hold on to index funds for long periods of time to ride out any inevitable market dips that may happen. However, that also means that you’re not going to be discovering the next Facebook anytime soon, because the companies in an index tend to be established, consistent companies with a record of steady, if modest, growth. And while the likelihood of you discovering the next Facebook is pretty low to begin with, some investors would at least like to have the option.

No quick liquidity: Index funds work best within a long-term financial strategy. If you’re looking for quick returns after five years or so, your returns may not be able to keep up with inflation and you won’t be protected against any short-term market downturns. If you want to have access to interest-generating funds sooner rather than later, then a high-interest savings account might be more your thing.

Index fund vs ETF vs mutual funds

Not all ETFs and mutual funds and index funds, and vice versa. Here’s where they differ.

Index funds vs ETFs

Both index funds and ETFs basically aim to track a specific market and are usually not actively managed—unlike most mutual funds—meaning that they don’t have high fees associated with them, since a manager isn’t as actively involved. And like ETFs, index funds are best held for long periods of time.

However, index funds—like mutual funds—tend to have pretty high investing minimums, meaning that they can be quite prohibitive for novice investors who don’t have loads of starting capital just sitting around.

Second, ETFs trade like stocks. This means that investors can trade shares throughout the day, while index funds only trade once a day, after the market closes, which is when their price is set. So there’s a little bit less flexibility for buying or selling shares.

Another thing about ETFs is that it’s easier to get a mix of stocks, bond, and other assets through them. You can even buy gold ETFs, if that’s an area you’ve been keen on investing in.

ETFs are also famously low-cost: Because they don’t need to be managed, the fees associated with them are less than with mutual funds. Coupled with low to no investment minimums, ETFs are understandably a popular choice among first-time investors who aren’t able to drop a significant amount of cash into a fund in one go.

Index funds vs. mutual funds

Technically, an index fund is a type of mutual fund, but that’s where the similarity basically ends. The main difference between an index fund and an actively managed mutual fund is that fund managers in charge of a mutual fund actively try to outperform the market by regularly re-balancing portfolios, selling and buying assets, and reinvesting in different sectors that they believe have the potential for above-average growth. Meanwhile, index funds are just coasting, with the ultimate goal being to simply track the return of whatever market they’re based off. And instead of being composed of certain assets that the manager thinks will maximize the fund’s growth, an index fund contains all the assets in an index, and holds them in proportion to how they’re represented in the index.

Because of all this active managing and re-balancing and research needed to run a mutual fund, mutual funds have higher annual fees than index funds do.

Alternatives to investing in index funds

As mentioned before, index funds aren’t for everyone. If you’re looking for faster growth and want more control over what assets go into your portfolio, then an actively managed mutual fund might be your thing. Maybe you also feel confident enough to trade stocks yourself, and want absolute control over what assets to buy and sell, and when (in that case, we suggest keeping an eye out for low-cost trading platforms with commission-free trading).

If you fall on the other end of the spectrum and would really like a steady, long-term, and historically stable way to invest, then ETFs might be the way to go. While they’re similar to index funds, ETFs also bundle up a lot of different sectors into one share, and aren’t as limited by a specific index market. The whole thing gets even easier with the help of a robo-advisor, which can help spread your money across more sectors through ETFs, which can cover stocks, bonds, real estate, and international markets. That way, you’re not just stuck in one market and can diversify even further.

Warren Buffett (you might have heard of him) has famously stated that

“Diversification is protection against ignorance.”

He means that trying to pick “lucky winners” instead of spreading your money across various sectors will probably not be your best move. After all, research has shown that for the past fifteen years, nearly 92% of large-cap active-fund managers have been trailing behind the S&P 500.

By ensuring that you’re not putting all of your eggs in one basket, you’ll minimize the risk of losing all of your money in one fell swoop. After all, the likelihood of every single company in an index market crashing is lower than the likelihood of a highly hyped company crashing. And because index funds can cover a wide variety of assets, they give you access to any kind of company or asset traded on a market: We’re talking small, medium, and large-cap companies, Wild West sectors like cannabis or cryptocurrency, real estate, tech, bonds, and any other type of listed assets.

While mutual funds tend to be very actively managed, an index fund is happy to just meet the market.

Major banks such as TD, RBC, and Scotiabank will all offer index funds that track markets such as the Toronto Stock Market (known as the S&P/TSX), the Canadian Securities Exchange, the Vancouver Stock Exchange, and the TSX Venture Exchange. Some choices available for Canadian investors include the TD e-Series index fund, the RBC index fund, or the CIBC Canadian index fund.