Luisa Rollenhagen is a journalist and investor who writes about financial planning for Wealthsimple. She is a past winner of the David James Burrell Prize for journalistic achievement and her work has been published in GQ Magazine and BuzzFeed. Luisa earned her M.A. in Journalism at New York University and is now based in Berlin, Germany.
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
As the name suggests, an index fund is a type investment that’s basically a mini-me of an established market index, such as aforementioned S&P 500 or the Dow Jones Industrial Average. This means that an index fund would mirror the market by including fractional shares of all components of a particular index, and would also therefore copy that market’s performance. So by buying an index fund, you’re buying a small slice of the entire market.
An index fund can be a mutual fund or an ETF. If you’ve recently invested in a fund that included all S&P 500 listed stock or ETFs that mirrored the Dow Jones, then congratulations, you’ve been trading in index funds!
Index funds are often an easy way of ensuring that your portfolio is diversified. As you probably know by now if you’ve spent even the slightest amount of time on this site, diversification is one of our favorite investing strategies, but you don’t need to just take our word for it—some guy named Warren Buffett (you might have heard of him) has famously stated that “diversification is protection against ignorance.” Meaning that unless you’re literally Warren Buffett’s clone or something, 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.
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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 or sector where you put all of your savings in going down. 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.
So this is where index funds come in handy. Another aspect that makes index funds attractive to a wide variety of investors is that they don’t require a lot of work on your part. Since they mirror the market’s performance, you’re not concerned with beating the market, a.k.a picking out “winners” that will outperform the market’s annual growth. You’re just coasting along, benefiting from the market’s long-term growth and saving yourself the trouble of extensively researching and selecting individual stocks. Therefore index funds tend to be appealing options for investors who’re more comfortable or confident with passive investing style, where the emphasis lies in mirroring the market instead of constantly trying to beat it. While mutual funds tend to be very actively managed, an index fund is happy to just meet the market.
Index fund vs ETF vs mutual funds
So we’ve mentioned that investing in certain ETFs or funds can be a way of investing in an index funds. But 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 such high fees associated with them, since a manager isn’t as actively involved. And like ETFs, index funds are usually the most effective when they’re 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.
Secondly, you also have to consider that 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 on when you can buy or sell 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 also famously low-cost: Because they don’t need to be managed, they usually have way less fees attached to them than other funds like mutual funds. Coupled with low to no investment minimums, ETFs are understandably a popular choice among first-time investors who aren’t necessarily 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 neds. The main difference between an index fund and an actively managed mutual fund is that fund managers in charge of a mutual fund will be actively trying to outperform the market by regularly rebalancing 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 rebalancing and research needed to run a mutual fund, it’s also natural that mutual funds have way higher annual fees than index funds do.
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 market indexes of its own, and the corresponding index funds to track them.
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.
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 maintenance 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 skip trading commissions in particular, since you don’t really need someone to actively manage the fund in the first place. Low-cost index funds also usually don’t have investment minimums, which can be a great benefit for first-time investors just starting out.
S&P 500-tracking 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
If you’re looking for index funds that track international stock markets, most of them will probably be focusing on the MSCI indexes. 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%.
U.S. bond index funds
If you’re keen to get involved in the U.S. bond market, then there’s an index fund for that. Some low-cost contenders include the Vanguard Total Bond Index and the Northern Bond Index, which both have expense ratios of 0.15%.
Pros and cons of index funds
Index funds can be an appealing way for first-time, busy, and cautious investors as well as those on a budget 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.
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 intricately research specific companies.
Low costs. Especially when compared to traditional mutual funds, index funds tend to have much lower fees. Like we mentioned, no active managing means less annual fees, and low to no trading commissions. So usually, 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 mirror the entirety of a certain market index and also 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!
Low flexibility. For an investor who’s keen to have a say in where their money goes or likes experimenting with different kinds of assets, an index fund can be a real bummer. One of the traits of index funds that make them so appealing to passive investors also can make them pretty 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 if you’re sticking to index funds.
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.
How to invest in index funds
Index funds are a relatively simple way for investors to participate in the market, and getting started is pretty similar to investing in a mutual fund. Here’s what you need to do:
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? Or do you want to focus on bonds? Or perhaps you’re more interested in focusing on small-cap companies? There’s a market for all of that, and a corresponding index fund.
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 rebalancing your portfolio if the proportions in the index shift. It’s like having a personal fund manager, at a fraction of a fraction of the cost.
Choose a broker
You can actually purchase index funds directly from mutual fund issuers like Vanguard or Fidelity or any other big-name company. The problem with that is that you’ll only really be able to buy funds from that specific company—no one likes selling their competition’s product, after all.
So if you want to have options, an online brokerage is probably your easiest—and cheapest—bet. 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 at an online brokerage and start buying index funds without even having to set down that breakfast burrito you’ve been working on.
And if you want to make sure you’re covering your bases and getting diverse market exposure, then signing up with a robo-advisor might be a good choice. In addition to automatically receiving a diversified portfolio, you’ll also be investing in one of the most cost-effective ways possible: Robo-advisors tend to have the lowest fees of all investing platforms.
Make the trade
Once you’ve decided what funds and what 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.
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!
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 perhaps 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.
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