If you've been paying attention to conversations about investing, you've probably heard index funds mentioned more than a few times. They're a favourite among long-term investors for good reason: they offer a simple, low-cost way to build a diversified portfolio without spending hours researching individual stocks.
In this guide, we'll walk through what index funds are, how they work, and the practical steps to start investing in them.
What is an index fund?
An index fund is an investment that mirrors the performance of a market index by holding all (or a representative sample) of the securities in that index. It can be structured as amutual fund or anexchange-traded fund (ETF)and tracks indexes like the S&P/TSX Composite Index or the S&P 500.
Index funds are popular with people who prefer apassive approach and want exposure to long-term market growth. Because an index fund gives you access to dozens — or even hundreds — of stocks within a single market, portfolio diversification is built right in.
What is a market index?
A market index is a hypothetical portfolio of investment holdings that represents a segment of the financial market. Think of it as a thermometer for the stock market or a specific sector.
Common indexes include:
S&P/TSX Composite Index: Tracks the largest companies on the Toronto Stock Exchange.
S&P 500: Tracks 500 of the largest U.S. companies.
MSCI World Index: Tracks companies across 23 developed countries.
When you hear on the news that "the market" is up or down, they're usually referring to the performance of a major index.
How do index funds work?
When you invest in an index fund, your money is pooled with money from other investors to buy a portfolio of assets that matches the components of a specific index. The fund manager purchases the stocks or bonds in the exact same proportions as they appear in the index.
Because the goal is simply to mirror the index rather than beat it, the fund is managed using a rules-based approach designed to track the index. This passive management style means less buying and selling behind the scenes — which translates to lower costs and a more straightforward investing experience.
Index funds vs. ETFs vs. active mutual funds
An index fund is a strategy, while MFs and ETFs are the vehicles used to deliver that strategy. Here's how they compare:
Fund Type | Management Style | Trading | Typical Fees |
|---|---|---|---|
| Index MF | Passive (tracks index) | Priced once daily | 0.05% – 0.50% |
| Index ETF | Passive (tracks index) | Trades throughout day | 0.05% – 0.50% |
| Active MF | Active (tries to beat market) | Priced once daily | 1% – 2% |
Active mutual funds employ managers who pick investments in an attempt to outperform the market. Because this requires more research and frequent trading, active mutual funds typically come with higher fees than passive index funds.
Should I invest in index funds?
Index funds aren't a great fit for every investor; it all depends on your personal goals, style, and comfort level.
Index funds come with several advantages:
Low cost: Index funds typically have lower fees because they track an index instead of relying on ongoing stock selection and frequent trading.
Lower transaction costs: You can gain broad exposure without buying and selling many individual securities, which can reduce trading fees.
Long-term growth potential: You can participate in a market's overall growth without trying to time short-term price moves.
The key word here is "long-term." Since your investments will be mirroring an index, it's natural that there will be ups and downs in the short term.
Historically, broad markets have tended to grow over long periods, though returns can vary significantly year to year. Some investors, including Warren Buffett, have argued that low-cost index funds can outperform many actively managed funds over long periods after fees—though results vary.
The downsides to consider:
Limited customization: Index funds follow an index, so you generally can't choose individual holdings or intentionally overweight specific sectors.
Returns generally match the market: Because the goal is to track an index, returns typically stay close to the market's performance (before fees).
Full market exposure: If the underlying market falls, the fund's value will usually fall as well.
How to invest in index funds in 3 steps:
Getting started with index funds is a straightforward process that you can break down into a few manageable steps.
1. Know which market index you want to draw from
Index funds mirror specific indexes, so you have a variety of options. Do you want to invest in an S&P/TSX Composite Index fund, where you'll have access to large Canadian companies? Or the S&P 500, which covers the 500 largest publicly traded U.S. companies?
Your choice depends on your personal financial goals and how you want to build your portfolio.
2. Decide how you'll buy your funds
You'll need to go through an investment platform or brokerage. Your options range from self-directed brokerages (where you buy and sell yourself) to robo-advisors (which manage investments for you). Keep in mind that more service typically means higher fees.
3. Compare costs
The costs of investing in index funds will depend on what investment platform you choose. Some accounts will have steep account minimums, while others might have higher investment minimums. Watch for commissions, transaction charges, and any ongoing service or account fees.
Costs and fees to watch for
While index funds are known for being cost-effective, they're not entirely free. Common fees include:
Management expense ratio: An annual fee (typically anywhere from 0.05% to 0.50% for index funds) that includes all of the costs of managing a fund including operating expenses and taxes
Trading commissions: Fees charged when you buy or sell ETFs, though many platforms now offer commission-free trading
Foreign withholding taxes: Applied to dividends from international holdings
Keeping your fees low is one of the more reliable ways to improve net returns over time, since fees directly reduce what you keep.
Risks to know before investing
All investments carry some level of risk, and index funds are no exception. The primary risk is market risk — because an index fund mirrors a specific market, if that market experiences a downturn, your fund will drop in value as well.
Other risks include:
Concentration risk: If an index is heavily weighted toward one sector (like Canadian financials or U.S. tech), a slump in that industry will hurt performance.
Tracking error: Small differences between the fund's returns and the actual index, usually caused by fees and timing.
Understanding these risks can help you stay the course during inevitable market fluctuations rather than panic-selling at the worst possible time.
How many index funds should I invest in?
A single index fund can provide broad exposure, but combining funds across regions and asset classes can further diversify your portfolio. A common approach is to hold a mix covering different asset classes and geographies:
A Canadian equity index fund
A U.S. or global equity index fund
A bond index fund
This spreads your risk across markets that don't always move in the same direction.
Frequently asked questions (FAQs) about index funds
How do beginners buy index funds?
Open an account with an online brokerage or robo-advisor, fund it, then search for your chosen index fund and complete the purchase. Many platforms allow automatic contributions to build your portfolio over time.
Are index funds a good investment?
Index funds are widely considered an effective investment for long-term wealth building due to their diversification, low fees, and passive approach. Whether they're appropriate for you depends on your personal financial situation, goals, and risk tolerance.
Which index fund is right for me?
The right index fund depends on your financial goals, timeline, and risk tolerance. Many investors start with broad-market funds covering Canadian, U.S., or global markets before exploring niche indexes.
What if I invested $1,000 10 years ago?
While past performance doesn't guarantee future results, broad market indexes have historically trended upward over long periods due to compounding growth. This is why patience and consistency matter more than trying to time the market.
