What is an Index Fund?

What are Index Funds

What are Index Funds

An index fund is a basket of investments — usually stocks or bonds — that tracks the performance of a specific sector or market. Because the investments in an index fund are picked for you, index funds can be a relatively simple and convenient way to invest in the stock market. 

How do index funds work, and should you invest in one? Let’s take a closer look and see.  

What is an index fund? 

Recall that a market index is simply a hypothetical portfolio that tells you how the economy (or a segment of the economy) is performing. An index fund simply turns this theoretical portfolio into an investment. For example, an index fund could track the TSX, or it could focus on a specific sector of the economy (mining, banking, or technology). It could even focus on a certain investing strategy, such as growth or ESG investing

Buying a share in an index fund means you’re spreading your money across all the companies in the fund, without requiring you to pick those companies yourself. It’s what some might call a “passive” approach to investing. Instead of researching companies and handpicking stocks, you sit back and go where your index market goes. 

An index fund has a fund manager who continues to align the fund with the market index. To be clear, this fund manager isn’t trying to beat the market. They only want to match it as closely as possible. They may occasionally trade investments to keep the index fund tracking with the underlying market. But, unlike mutual fund managers, who try to outperform the market, index fund managers won’t buy and sell securities to make bigger gains.

What are some examples of Canadian index funds? 

In Canada, you can find index funds for practically anything, from sector-focused funds to international ones. Here are just a few you may come across. 

CIBC Canadian Index Fund  

The CIBC mirrors the performance of the S&P/TSX Composite Index, which contains Canada’s largest companies. The CIBC is one of the most well-known index funds in Canada, with holdings in companies as big as Shopify, Enbridge, and Royal Bank. 

For beginning investors, the CIBC fund may seem like a good place to start investing, but there’s one catch: the minimum investment for a CIBC share is $50,000. That could be a steep entry, especially if you don’t have that much to invest. 

Vanguard FTSE Canada All Cap Index ETF (VCN) 

The VCN is one of Canada’s premier index funds, as it tracks numerous companies from Canada’s equity market. The fund has mostly large cap companies (around three-fourth of the fund is large caps), though it does have its fair share of mid to small cap companies, too. Investing in the VCN will expose you to most of Canada’s major market sectors, with financials and energy having the largest holdings.

S&P Canadian Dividend Aristocrats Index Fund 

An aristocrat is a dividend stock that has raised its dividend for at least five years in a row. This index fund, then, matches the performance of Canada’s top dividend aristocrats (around 83), including Keyera Corp, Enbridge, and Pembina Pipeline. 

What is the average index fund return? 

Between 1960 and 2020, the average annual rate of return on the S&P/TSX Composite Index was around 9.3% per year.(1) All things considered, that’s a pretty good ROI. Of course, that doesn’t mean every Canadian invested in this index earned 9.3% every year. It’s simply the average of those sixty years, both the highs and the lows. 

Likewise, though the S&P/TSX Composite Index had an average annual rate of return of 9.3%, that doesn’t mean every index fund that tracked this index had the same ROI (though it was probably close to that percentage). Some index funds track the Composite Index very closely, while others track it loosely, meaning they probably don’t have shares in every company. 

Index funds also come with management expense ratios (MERs), which can slightly affect its rate of return. Depending on how closely your index fund tracks the market index, as well as the fees you pay to your fund manager, your index fund may earn more or less than the index’s average rate of return. 

How to invest in an index fund

Buying shares in an index fund really comes down to three things: pick an index you want to track, buy shares through a brokerage, and hold on for the long haul. 

1. Pick an index 

The first step is often the most difficult — select a market index to track. The sheer number of indexes in Canada, not to mention the world if you go international, can make this choice feel daunting, if not downright stressful. 

The most popular indexes are those that track the largest companies, such as the S&P/TSX Composite Index or the S&P 500. Both of these can give you broad exposure to different market sectors, while using diversification to limit downside losses, too. 

But you don’t have to take this popular approach. You may want to choose an index that tracks the best tech stocks. Or, if green living is your thing, you could put your money in a fund that tracks the most sustainable companies. 

The point — you have options. And, even when you choose a market index to follow, you still have options. Many market sectors have numerous index funds that follow it. You may want to track the S&P/TSX Composite Index, for instance, but, once you start looking for index funds that track it, you’ll find several funds, each differing by costs and how closely they follow their index. 

The goal, then, is to find an index fund that closely tracks your target market at the lowest cost. The fees on index funds are typically low (especially when compared with mutual funds), but they could vary from brokerage to brokerage. Likewise, make sure the index fund doesn’t have a minimum investment, as that could become a barrier for you. 

2. Buy shares

To buy shares in an index fund, you’ll need to open an online brokerage account. Look for a brokerage with good customer service, low fees, and an easy-to-understand trading platform. Once you have one, buying shares is as easy as searching the fund’s ticker and placing an order with your broker. 

3. Stay invested for the long-haul 

Similar to investing in individual stocks, once you buy shares in an index fund, stay invested for the long-run. Even if you see major growth in a short period of time, that doesn’t mean you should sell your shares. Let your money grow steadily over time, and only pull out when you know you’re ready.  

What are the benefits of an index fund? 

An index fund is a great way for investors to benefit from the performance of the overall market, especially if they don’t have the time, knowledge, or patience to analyze and pick individual stocks. In addition, here are five of the main reasons investors find index funds useful. 

1. Invest in the whole market 

An index fund gives you an indirect way to buy all the securities in a single market index, such as the S&P/TSX Composite Index. 

The fact that you can spread your money across every company within a market index at the click of a button is amazing in itself, not to mention the return you’ll get if you keep your money invested for the long run. Without the help of an index fund (or any fund for that matter), you would have to buy shares in each company yourself, if you wanted to track the entire market.

2. More approachable 

An index fund is one of the easiest investment products out there. You simply buy shares in an index, sit back, and let the index track its targeted market. No day trading. No complicated investing strategies. When the underlying market does well, so does your index fund. When it performs poorly, the index fund’s diversification will hopefully blunt the downside losses. 

3. Lower costs

Because index funds are passively managed, they come with lower management expense ratios (MERs). Their fund managers trade investments far less frequently, reducing trading and transaction fees, and you won’t have to pay the fund manager to analyze, research, and choose stocks. 

4. Instant diversification 

When you diversify an investment portfolio, you spread your money across numerous companies and sectors to prevent one company- or sector-focused downturn from hurting your overall gains. 

Depending on the market you choose to follow, an index fund can do this diversification work for you. By investing in an index fund that tracks the TSXm, for instance, you spread your money across all of Canada’s sectors. Even an index fund that tracks a specific sector, such as banking or financials, will prevent you from suffering major losses from a single company’s downturn. 

This built-in diversification is one of the primary reasons index funds are a great investment for beginners, as they help you invest at a much lower risk. 

5. Plenty of options 

Index funds come in a surprising amount of variety. You can buy shares in index funds that focus solely on the performance of small cap, mid cap, or even large cap companies. Or you can buy shares in index funds that track certain sectors of the economy. 

Index funds aren’t limited to stocks, either. You can find index funds that track the bond market, which can be another way for you to diversify your portfolio with little work.  

What are the drawbacks? 

Of course, as with any investment, index funds aren’t one-size-fits-all. Though certain investors may find index funds helpful, others may not want to take such a passive approach. Before you take off investing in index funds, here are some downsides to consider.

1. Limited control 

With an index fund, you have no say in what stocks the fund manager picks. You could have stocks that you like, sure. But you may have stocks whose companies don’t align with your values or ones you don’t particularly want. 

Since a share in an index fund means what you’re offered is what you get, you’ll have to deal with the stocks you don’t care for, especially it means getting the ones you really want. Similarly, your fund manager could overlook stocks that you really want, though you could always buy these stocks yourself if you want them that bad.   

2. Limited gains 

Perhaps the biggest drawback with index funds is their conservative gains. An index fund may curb certain risks associated with individual stock investing. But it will also curb the chances that you’ll find the next Shopify or Amazon. Your investment will always track an index, never beat it. If you’re okay with average returns, that might not matter much. But if you want to make bigger gains, you’ll probably want to invest in individual stocks, too. 

3. Longer time horizon 

Finally, to see significant returns on index funds, you’ll want to keep your money invested for a long time (think decades, not years). Though this isn’t a major drawback — a long-term investing strategy is great to have — if you’re near retirement, this could be somewhat problematic.  

What are some alternatives to index funds? 

Index investing isn’t the only way to diversify your investment portfolio, though it’s usually the most cost-efficient method. If you want a more hands-on approach to investing, or you want to try to beat the market, you have options. The three most common are individual stocks, exchange-traded funds (ETFs), and mutual funds. 

Individual stocks 

The most active, hands-on approach to investing in the stock market is to buy individual stocks. Instead of relying on a fund manager to pick your stocks for you, you can build a portfolio of numerous companies, creating your own “index” of sorts that might outpace the overall market.

As the owner of a stock, you’ll benefit directly from a company’s growth. Rather than dilute your earnings with the ups and downs of numerous other companies (as an index fund does), you could make big gains when a company does well. Alternatively, you could lose a lot of money in a market downturn, especially if your individual stocks suffer greatly. 

Because of the higher risk for loss, stocks require far more time, knowledge, and patience than index investing. You’ll also be in charge of managing and rebalancing your portfolio, which entails occasionally trading stocks to balance out your portfolio’s risks. 

Exchange-traded funds (ETFs)

An exchange-traded fund (ETF) is very similar to an index fund. Like an index fund, an ETF is a basket of investments. An ETF tracks a market index (usually the same ones as index funds), and because it’s passively managed, an ETF has low commissions and trading fees.

The difference between an index fund and an ETF is in the name — exchange-traded fund. An ETF is a basket of investments that trades on an exchange. That means, as long as the market is open, you can buy or sell an ETF. To trade an index fund, on the other hand, you have to wait until the market closes. For day traders, that could be a major hassle. If your index fund makes a major leap, one that could leave you with a lot of wealth, you’d have to wait until the end of the day before you could sell. By that time, the price of the index fund may have gone down, leaving you with no gains. 

If you want to trade your fund like a stock, an ETF can be a great alternative to index investing. Just keep in mind that the more frequently you trade your ETFs, the more you’ll probably pay more commission fees. And, though day trading could help you capture certain short-term price movements, you’ll rarely earn significant wealth as a day trader. Whether you have an ETF or an index fund, your best strategy is to keep your money invested for the long-term.  

Mutual funds

As with ETFs, index funds and mutual funds share some similarities. They’re both diversified baskets of investments that you can trade after the market closes. 

The main difference between the two is that mutual funds tend to be more actively managed. That means the fund manager of a mutual fund isn’t trying to track an index. They’re trying to beat it. Their job is to pick a collection of stocks that will outperform the market. 

They could do this successfully, which means better gains for you. But it’s not guaranteed that they will. In fact, while mutual fund managers may be right some — or even most — of the time, they’re not right all of the time. While, sure, they could beat the market in the short-term, it’s rare for them to consistently outpace the market for longer periods of time. 

Regardless of whether a mutual fund manager can outpace the market, you’ll pay higher MERs for the fund manager’s trading activities. Depending on the MER, that means even if your mutual fund outpaces the market, your MER could eat into your returns, making them more or less the same as an index fund. 

What are some low-cost index funds? 

Though index funds are typically less expensive than mutual funds, they do vary by fee amongst themselves. You can compare index funds by their management expense ratios (MERs), which tell you how much you’ll pay each year in fees. For instance, an index fund with a MER of .10% means you’ll pay .10% of your account balance in annual fees. 

Fortunately, Canada has numerous low-MER index funds to choose from. Here are just a few.

  • Schwab S&P 500 Index Fund: MER of .02%
  • Vanguard Total International Stock Index Fund: MER of .17%
  • TD Canadian Index Fund: MER of .28%
  • RBC Canadian Index Fund: MER of .66%
  • Scotia Canadian Equity Index Fund: MER of .77% 

Are index funds good for beginners? 

Buying shares in an index fund is one of the easiest and most cost-efficient ways to start investing in the stock market. Though you won’t beat the market with index funds, you can still build wealth through steady, long-term growth. You’ll also benefit from diversification, which can help you balance losses with gains from companies within the fund. 

If you’re just starting out, an index fund can be a great way to dip your feet into the world of investing. You can even use index funds alongside other investments, such as individual stocks, bonds, real estate, commodities, and even currencies. 

With the sheer number of low-cost index funds in Canada, you should be able to find one that’s right for you. Check with your online brokerage to see which ones are available to you. Once you’ve selected an index to follow, keep your money invested for the long-haul. 

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a "top stock" is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a "top stock" by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.