Investing in Index Funds: A Guide

Curious about how to invest in index funds? Whether you are a beginner in the investment world or nearing retirement, index investing is a versatile strategy suitable for everyone. Even investment legend Warren Buffett endorses index funds for average investors. The major attraction lies in the low maintenance required and the minimal fees associated with them. This means significantly more money in your pocket—potentially tens or even hundreds of thousands of dollars over time.

Although index funds typically offer average returns, it’s important to note that around 90% of actively managed funds fail to outperform comparable indexes. By embracing a passive investment strategy with index funds, you accept average returns but enjoy a considerably lower cost. Over the years, the difference in management fees can be substantial. Here’s a guide on investing in index funds.

What is an index fund?

Before diving into the specifics of how to invest in index funds, it’s crucial to understand what an index fund is. Index funds are types of mutual funds or exchange-traded funds (ETFs) that aim to replicate the performance of a specific stock market index. Common indexes include:

• S&P/TSX Composite Index (Canada’s benchmark index)
• S&P 500 Index (America’s benchmark index)
• Dow Jones Industrial Average (DJIA, covering the largest 30 U.S. companies)
• Nasdaq Composite (focusing on over 3,000 technology companies)
• MSCI EAFE (tracking stocks from regions outside Canada and the U.S., including Europe and Asia)

Index funds operate passively, meaning that the portfolio manager does not engage in decision-making based on instinct or emotions. The index itself functions as an algorithm that mirrors market movements. Thus, if the market rises, so do index funds, and vice versa. Investors can expect average returns, which historically have been quite reasonable since public trading began.

Because index funds represent a diverse set of stocks, investors can avoid the hassle of selecting individual stocks and conducting research. The funds self-adjust according to market shifts, allowing you to relax once your portfolio is set. A passive investment strategy can help to manage your risk profile alongside market fluctuations.

What is an index fund vs. a mutual fund?

Having defined index funds, you might be wondering how they differ from mutual funds. Two primary distinctions exist: active management and fee structures.

Active management

Most mutual funds utilize active management. This means a portfolio manager constantly analyzes market conditions and adjusts investments accordingly. While this might seem beneficial, historically, around 80% of passive funds outperform their actively managed counterparts (this is an approximation).

Although 20% of funds may beat passive investments, selecting from them is often a gamble. Fund sellers frequently recommend funds with historically strong performance, but remember that past performance doesn’t guarantee future results. You might find a fund that beats the index one year, but not necessarily the next. While index funds may feel boring, accepting average returns is a sensible choice.

Management expense ratio

The management expense ratio (MER) differentiates index funds from mutual funds as well. Generally, mutual funds charge MERs between 2% and 2.5%, while index funds typically have fees ranging from 0.20% to 0.50% (with some exceptions). While this difference may seem minor, it has significant implications over the long term. You could be sacrificing substantial amounts of money.

For example, suppose you invest $100,000. A mutual fund with a 2.5% MER would incur $2,500 annually, while an index fund with a 0.25% MER would cost just $250 each year. These fees accumulate, cutting deeply into your returns. If you eventually reach a million-dollar portfolio, you could be shelling out $25,000 annually for fees with mutual funds. Many people might think they won’t accumulate such wealth, but that is entirely within reach after a few decades of investing.

Bank employees often promote actively managed mutual funds since they maximize profit for the institution (and sometimes for the individual). However, these options are rarely in your best interest. Some mutual funds even claim to track indexes but still come with higher MERs.

If using a robo advisor, be aware they typically charge an additional management fee averaging around 0.50%. This still results in total expenses below 0.80%, leading to considerable savings.

Aiming to avoid high fees should be essential in your investment strategy. Consider a scenario where the stock market returns 7% annually, but you’re invested in a mutual fund charging a 2.30% MER. For that mutual fund to even match the performance of an index fund, it must outperform the market by around 2%. This is quite unlikely. Avoid letting fees eat away at your returns; adopting a passive approach with index funds can alleviate this concern.

How the management expense ratio affects your return

If you’re uncertain about how fees impact your investments, let’s explore some comparisons between mutual funds and index funds. For this comparison, I specifically selected funds from major banks to offer a level playing field. The performance contrast from March 2011 to March 2021 may astonish you.

Fund name	10-year annual return	MER	Type of fund
BMO Canadian Equity ETF	5.03%	0.94%	Index fund
BMO Canadian Equity Fund	4.94%	2.39%	Mutual fund
CIBC Canadian Index Fund	5.01%	1.14%	Index fund
CIBC Canadian Equity	4.36%	2.2%	Mutual fund
RBC Canadian Index Fund	5.38%	0.66%	Index fund
RBC Canadian Equity	4.05%	1.89%	Mutual fund
Scotia Canadian Equity Index	5.12%	1%	Index fund
Scotia Canadian Growth	4.84%	2.09%	Mutual fund
TD Canadian Index e-series	5.92%	0.32%	Index fund
TD Canadian Equity Fund	4.19%	2.17%	Mutual fund

What’s noteworthy here is that, in all instances, index funds outshine mutual funds. The comparison strictly involved bank index funds against their corresponding mutual funds, ensuring fairness. It’s evident that only TD and RBC maintain relatively low MERs. Selecting an exchange-traded fund (ETF) would typically result in even lower fees; for example, I utilize the Vanguard All-Equity ETF Portfolio (VEQT), which has an MER of just 0.25%.

It’s astonishing that financial institutions try to persuade investors to shy away from average returns with index funds, claiming that personal service is superior. During my extensive 12-year experience with actively managed funds, I observed that they consistently underperformed against the index. In fact, I found myself in a worse situation because the “financial advisors” I collaborated with often lacked necessary expertise, leading to ill-fitting mutual fund selections for my profile. Naturally, at the time, I trusted their guidance.

Transitioning to index funds was a pivotal move. My fees decreased while returns increased, and I gained insights into managing my finances. If I could make this change, so can you!

Understand your investor profile

Before outlining how to invest in index funds, it is essential to assess your investor profile, as this will influence your investment approach. When investing, consider two asset types: fixed income and equities.

Fixed income components include items like bonds, term deposits, and money market funds. These typically maintain value, but returns are usually modest. Equities, on the other hand, encompass stocks and carry a higher risk but offer the potential for greater returns. Striking the right balance is a cornerstone of investment strategy, referred to as asset allocation.

For instance, someone in their early twenties might feel comfortable taking on more risk because their savings won’t be needed for many years. But if they intend to buy a house within five years, placing funds in fixed income would be wiser to safeguard their down payment.

Many novice investors prefer lower risk and might lean toward fixed income investments, yet this approach may not be sustainable since fixed income yields around 2% annually, often falling short of inflation. Hence, some fixed income should be included in your portfolio.

Some advisors historically suggested using age as a benchmark for fixed income allocation: for a 30-year-old, a mix of 30% fixed income and 70% equities is typical. I find this outdated; I turn 42 this year and only allocate 20% of my retirement account to fixed income.

Additionally, many claim they can tolerate risk but panic when market downturns occur. You’ll truly comprehend your tolerance only when confronted with a sudden market decline of 25% or more. If you can maintain composure during such fluctuations, you’re likely on the right track.

How to invest in index funds

Now that you are ready to begin, you may be wondering how to invest in index funds. The process is quite straightforward and can be approached in three primary ways.

• Utilize Tangerine’s investment funds or global ETF portfolios
• Opt for a robo advisor
• Engage in DIY investing through a discount brokerage

Your choice will depend on your comfort level, but remember that you can change your strategy later on. I began with Tangerine index funds before transitioning to TD e-series funds and ultimately took the DIY path as it proved the most economical.

Bear in mind that when I first started investing, there were no robo advisors available, limiting my options. Nowadays, there is a wealth of resources available for investors, regardless of initial capital. Here’s a quick overview of your options.

Tangerine funds

Tangerine offers two types of index fund options: Investment funds and global ETF portfolios. Within the investment fund category, there are five distinct funds catering to different investor profiles, each with a management and administrative fee of 1.07%. The newer global ETF portfolios consist of three options, featuring a lower management and administrative fee of 0.77%. Clearly, selecting the global ETFs is more cost-effective, provided that there’s an applicable portfolio for your investment profile.

Similar to robo advisors, Tangerine’s funds are entirely automated, meaning minimal effort is required on your part. The 0.77% fee encompasses both the MER and administrative costs, plus there are no brokerage fees associated with your investments. Overall, Tangerine is an excellent option for customers already banking with them and wishing to consolidate their finances. The fee structure aligns with that of robo advisors, making it an effective starting point. Note that you must have a Tangerine account to invest here.

Robo advisors

Robo advisors effectively combine technology with personal support. While they primarily rely on algorithms for investment decisions, humans are also present behind the scenes to assist customers. When setting up an account, you will answer a series of questions, which informs a tailored portfolio recommendation.

One of the major perks of robo advisors is the array of options available. Each robo advisor offers various portfolios, with some emphasizing responsible investing and others being suitable for specific savings plans. Most robo advisors have fees hovering around 0.40% to 0.80%, so choose one that best matches your needs.

If you are new to investing and lack a preference for specific brands, selecting a robo advisor is a practical choice, as many provide alluring sign-up bonuses. Here are a few recommended robo advisors:

• Justwealth – Receive up to $500 upon joining
• Wealthsimple – Get $50 when you sign up
• CI Direct Investing – Enjoy a year of $10,000 managed for free
• RBC InvestEase – A solid option for existing RBC customers
• Nest Wealth – Best for high-net-worth individuals seeking lower fees

Do-it-yourself / discount brokerage

Taking the DIY approach may seem daunting, but you might feel ready after digesting this information. Numerous all-in-one ETFs are available for individual purchase. These ETFs are utilized by robo advisors, allowing you to bypass the intermediary, ultimately saving around 0.50% in management fees. By reducing costs, you benefit from higher overall returns.

As a DIY investor, you only incur the MER alongside any brokerage fees. Personally, I make approximately two trades annually, resulting in a mere $20 in fees ($10 per trade) with TD Direct Investing. Other discount brokerages have similar fee structures, so any choice you make will likely be favorable. If you plan on making monthly contributions, Questrade is a fantastic option since they permit you to buy ETFs without incurring costs. You’ll only pay when you sell.

Notably, all-in-one ETFs manage their own rebalancing, demanding little upkeep from you. Just ensure you select an ETF with an asset allocation that corresponds to your investment profile. Here are some well-regarded all-in-one ETFs:

• VEQT – Entirely focused on equities (ideal for long-term investors)
• VGRO – Comprising 80% equities and 20% fixed income (often the best choice for novice investors)
• VBAL – With a composition of 60% equities and 40% fixed income (great for those seeking lower risk)

Which index fund should I invest in?

New investors often gravitate toward VGRO, as it balances 80% equities with 20% fixed income, making it a suitable choice for most individuals. You can consistently invest in VGRO without constant concern for additional adjustments.

That said, it’s crucial to think about your risk tolerance and investment horizon. A young investor in their early twenties might consider VEQT if they’re prepared to endure market variations. Alternatively, those closer to retirement may benefit from VBAL’s higher fixed income exposure.

Consider your individual circumstances as well. For instance, if you receive a defined benefit pension from your job, that acts like a substantial bond, allowing you to invest entirely in equities (VEQT) since you would still have guaranteed income during retirement.

I hold VEQT in my TFSA as I view it as a long-term investment and do not plan to withdraw from it. In contrast, I opt for VGRO in my RRSP and taxable trading account, as those align better with my investment approach and risk tolerance.

With various companies offering all-in-one ETFs, there’s no need to overthink your choice. Pick one and begin investing. Avoid complicating your portfolio with multiple ETFs, especially niche selections. For additional guidance, check out Boomer and Echo’s insights on top ETFs and model portfolios.

Do index funds give dividends?

ETFs do distribute dividends. If you’re unfamiliar with dividends, they represent payments made to shareholders by companies. Since ETFs encompass numerous shares, you receive dividends, with payment schedules varying between monthly, quarterly, or annually.

For those using Tangerine or a robo advisor, dividends are typically reinvested automatically. Conversely, if investing through a discount brokerage, you’ll need to establish a dividend reinvestment plan (DRIP). Doing so is simple—just call customer service and request DRIP setup for your account.

When doing this, ensure they apply DRIP to all your accounts and purchases, as some brokerages are peculiar. Even if your account is set for DRIP, new ETF purchases might not be automatically included.

Reinvesting dividends is advantageous because you incur no brokerage fees while acquiring more shares. Moreover, this compounding effect further grows your portfolio.

Can you lose money in an index fund?

As with any investment, index fund values can decrease. However, given their diversified nature—often tracking hundreds of stocks—individual drops have minimal effect on overall performance. While market declines of 10% or more can happen, these trends are normal and may even present buying opportunities.

Consider it this way: a price drop allows you to purchase investments at a lower cost. Once prices rebound, significant gains can occur. Contrarily, many investors err by buying high and selling low due to emotional impulses.

Recent investment trends, such as cryptocurrency and meme stocks, illustrate this. By the time you hear about a hot investment, it’s likely overpriced. When they subsequently decline, inexperienced investors tend to sell off, a poor long-term strategy.

By sticking with index funds, you aim for average returns while avoiding the relentless portfolio monitoring others endure. Set up automatic contributions and let it be.

Final thoughts

Index funds may be seen as dull, but they provide a solid foundation for novice investors and seasoned individuals alike, requiring minimal effort. Thanks to tools like robo advisors and all-in-one ETFs, you can start your investment journey within minutes. Begin index investing today and potentially save yourself thousands.