For many new investors, particularly those with smaller accounts, it can be easy to feel disheartened by the high price tags of some well-known stocks.
This often leads to the temptation of chasing volatile meme stocks or unpredictable penny stocks in search of quick gains. However, this approach can be risky and is generally not the best way to build a solid investment foundation.
The good news is, you don’t need to amass a large sum of money to buy individual shares of each major stock to achieve diversification. Index funds offer a much simpler and more effective solution. These funds pool money from many investors to buy a portfolio of stocks or bonds that mirror a specific market index.
And when these index funds are structured as an exchange-traded fund (ETF), they trade on an exchange just like individual stocks, offering the flexibility and ease of stock trading with the diversified benefits of mutual funds.
This means with even a modest investment, like $500, you can gain exposure to a broad range of assets through a single purchase. Here’s how they work and my favourite pick.
All you need to know about index ETFs
An index is like a recipe for a stock portfolio. It’s a set of rules that determines which stocks are included and how much of each stock is in the mix. Think of it as a shopping list for stocks. The index tracks a specific segment of the stock market by including a collection of stocks that meet its criteria.
A great example of an index is the CRSP US Total Market Index. This index is comprehensive, covering over 3,500 companies across various sizes, from the largest “mega-cap” companies to smaller “micro-cap” firms. It’s designed to represent 100% of the investable U.S. equity market, making it incredibly diverse.
When you hear that an index encompasses the entire market, it means that it covers a broad spectrum of companies, offering exposure to virtually every sector and industry in the U.S. stock market. ETFs that track indexes like the CRSP therefore work by buying and holding all the stocks represented.
When you buy a share of such an ETF, you’re essentially getting exposure to all the underlying stocks in that index. This means with a single transaction, you can invest in a vast array of companies spanning various industries and market capitalizations.
This approach offers several benefits. First, it provides broad market exposure, which helps diversify your investment and reduce risk. Secondly, because these ETFs simply replicate the index, they typically have lower management fees compared to actively managed funds. Lastly, buying a share of an index ETF is as straightforward as buying a share of any stock.
A great index ETF to invest $500 in
To track the CRSP US Total Market Index, investors can buy Vanguard U.S. Total Market Index ETF (TSX:VUN) for a 0.16% management expense ratio.
To put it in perspective, a $10,000 investment in VUN would only cost around $16 in annual fees, which is far lower than comparable mutual funds.
Despite its high diversification, VUN hasn’t been a slouch in terms of historical performance either. Over the last 10 years, the ETF has returned an annualized 13.45%.
