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What is an index fund? (and why the best investors use them)
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Updated: November 01, 2024
Ever wondered why some of the world's most successful investors swear by index funds?
Investing legends like Warren Buffett and John Bogle strongly advocate for index investing.
So, what is an index fund? How do you invest in one? And how do you become wildly wealthy with a few tips and tricks? Let's find out!
An index fund is a type of mutual fund designed to passively track a specific stock market index, such as the S&P/TSX Composite Index (the benchmark Canadian index) or the S&P 500 Index in the United States. Index funds allow investors to mimic the performance of one or more of these indices — typically at a much lower cost than an actively managed mutual fund.
Index funds are well suited for individual investors who don’t have the time, skill or patience to analyze and manage a portfolio of individual stocks or actively managed mutual funds. Furthermore, because of the relatively low cost and broad diversification that index funds offer, passive investors can typically outperform active investors over the long term, providing a sense of security and stability.
| Feature | Index fund | Actively managed mutual fund |
|---|---|---|
| Management | Follows a specific index with no active management | Managed by a team of professionals who make investment decisions |
| Investment Strategy | Aims to match the market's performance | Attempts to outperform the market |
| Fees | Lower fees due to passive management | Higher fees due to active management |
| Performance | Generally matches market performance | Can vary significantly and may outperform or underperform the market |
| Risk | Lower risk as it diversifies broadly across an index | Potential for higher risk due to active strategies |
| Tax Efficiency | More tax-efficient with fewer trades | Less tax-efficient due to frequent trading |
| Transparency | Holdings are transparent and disclosed regularly | Holdings are disclosed periodically |
How an index fund works
Index investing is often referred to as "passive investing." It’s passive because, rather than having a fund manager exercising their judgement to determine which stocks to buy or which methodology to follow, the fund manager simply creates a portfolio with holdings that mirror the stocks or bonds of a particular index. The idea is to hold every security in the benchmark index and match its performance.
Passive investors don’t try to “beat the market." Instead, they create a portfolio of index funds that attempt to mirror the market – specifically, by buying stocks of every company listed on an index to match the overall performance of the entire index. Such a strategy can help balance the risk in an investor’s portfolio, as market ups and downs will be less tumultuous across an index than individual stocks.
So, as a new investor that knows how they work, can you buy index funds in Canada?
Are index funds available in Canada?
Yes, index funds are available in Canada and are a popular investment choice for many Canadian investors. These funds are designed to mirror the performance of a specific market index, such as the S&P/TSX Composite Index, by holding a portfolio of securities that closely matches the components of that index. A variety of traditional, digital-only and robo-advisors/DIY investing companies offer a multitude of choices. Read about the most popular indexes below.
Brief history of index funds
Vanguard founder, John Bogle, also known as the father of index investing, started the first index fund in 1975. This fund, now known as the Vanguard 500 Index Fund, tracks the S&P 500 and has grown its net assets to $1.18 trillion (July 19, 2024). Today, index funds make up half of US stock fund assets.
Index funds have grown in popularity since John Bogle made them famous. Now, there’s an index and a corresponding index fund for practically every financial market, globally.
Popular indexes
We mentioned the S&P/TSX Composite Index in Canada and the S&P 500 in the US Other popular indexes include:
- Dow Jones Industrial Average (DJIA) tracks the 30 largest US firms
- Nasdaq Composite tracks more than 3,000 technology-related companies
- CRSP US Total Market Index representing large-, mid-, small- and micro-capitalization stocks in the US
- MSCI EAFE consisting of foreign stocks from Europe, Australasia and the far east
- Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index following the broad Canadian bond market
There are also many subsets of these indexes. For instance, an index fund tracking the Nasdaq-100 would invest in the 100 largest foreign and domestic companies listed on the Nasdaq Composite Index.
Indexes may use one of two strategies to construct them. One method is called cap weighting, which takes a company’s market price and the number of outstanding shares to determine its percentage weighting in the index. The larger the company, the larger the weighting in the index. The second method is equal weighting, and with this strategy, every company, regardless of its size, will be represented equally in the index.
The index may “rebalance” once per quarter to reflect market movements (share price appreciation or declines). It also may ‘reconstitute’ its index once a year, meaning it drops certain companies that no longer meet certain criteria or adds new companies that now meet the criteria.
Rebalancing your portfolio means adjusting your investments to maintain your desired asset allocation. It involves buying or selling assets to keep your risk level consistent, ensuring your investment strategy aligns with your financial goals.
That means that index funds that track these market indexes will also need to rebalance and reconstitute along with the index to continue matching its performance and minimise tracking errors (which reflect how closely the fund follows the index, with a smaller tracking error indicating better alignment).
Index fund facts
- An index fund is a portfolio of securities designed to mirror the make-up and performance of a particular stock or bond market index
- Index funds typically have lower MERs than actively managed mutual funds
- Index investing is often referred to as passive investing
- Index funds are designed to deliver market returns, minus a small fee
- Index funds should outperform actively managed funds over the long term due to lower fees and broader diversification
- Index funds help balance risk in an investor’s portfolio
Index funds vs. actively managed funds
Imagine saving hundreds or even thousands in fees over the years – that's the power of index investing.
While actively managed mutual funds attempt to outperform their benchmark by picking winning stocks and timing their investments, passively managed index funds sit back and let the market do its thing. The three main principles are:
- 1.
Markets rise over time (the stock market is up more than it’s down)
- 2.
It’s nearly impossible to predict which stocks will outperform
- 3.
Fees eat into investor returns, so it’s best to keep them as low as possible
The case for index investing: simplicity and cost efficiency
With so many personal finance bloggers and newspaper columnists touting the benefits of index investing with low-cost ETFs, it's likely you’ve heard the term before. This investment strategy is simple and quick to implement — you can set up the equities portion of your investment portfolio in about five minutes and then forget about it. Not only is it low-maintenance, but it often outperforms traditional mutual funds. In fact, studies suggest that index funds beat actively managed funds 95% of the time, largely because of lower fees.
Why active managers struggle to outperform
The idea that investment experts in financial hubs like Toronto and New York can’t consistently beat the market might seem surprising, but the data backs it up. A New York Times study looked at 452 domestic mutual funds over 20 years, and only 13 of these funds managed to outperform the S&P 500 after accounting for fees and taxes. The problem often lies in management fees, which are typically around 2% in Canada — among the highest in the world. These fees eat into returns and compound over time, making it difficult for active funds to keep up.
Market efficiency and its limits
The logic behind index investing comes from the Efficient Market Hypothesis, which claims that market prices reflect all available information. Over time, this means it’s nearly impossible to consistently beat the market. However, critics argue that markets aren't always rational in the short term. Rumors or earnings reports can cause wild fluctuations, and some argue that too much index investing could reduce market efficiency. Still, for most investors, focusing on low fees and long-term returns through index funds remains a winning strategy.
Index funds in Canada have lower fees
Active fund managers must pay for their research, analytics, fund managers, marketing and an army of advisors to sell them in the distribution channel. Canada, in particular, has a problem with fees. The latest research from Morningstar’s sixth Global Investor Experience Study gave Canadian investors a “below average” grade for fee experience. It showed that the average MER for an actively managed equity mutual fund was 2.28%.
Much goes into a fund’s expense ratio, including operating expenses, marketing, transaction fees, and accounting. More importantly, Canadian investors typically pay a 1% embedded trailing commission for equity funds and 0.50% for fixed-income funds.
Index funds, on the other hand, have little overhead compared to their actively managed counterparts. There’s no need for research and analysis, since they’re just replicating an existing market index. They incur fewer transactions and trading costs since they’re not timing the market and moving in and out of securities.
The result is that index funds typically cost one-third to one-half the cost of an actively managed mutual fund. That’s more money in the pockets of investors each and every year.
Think of fees as the ultimate investing handicap. If a stock market index returns 8%, an investor tracking it will see returns close to 8% (the market return minus its fee). An actively managed fund that charges 2.28% needs to outperform the market by 2% to make up for its higher fee.
Index funds have higher returns
Looking for more proof that low fees lead to higher returns? I looked at Canada’s big five banks and compared their expensive, actively managed Canadian equity funds to their low-cost Canadian index funds to see how they performed. Here are the results from 2014 to 2024:
As you can see, in nearly every case, the lower-cost index fund outperformed the higher-fee actively managed fund over 10 years. This aligns with Morningstar research, which suggests that fees best predict future fund performance. For example, funds with lower fees typically outperform higher-fee funds.
Active fund managers like to argue that index investors are settling for “average” returns. Why pay for average when you can invest in a mutual fund that will attempt to beat the market?
However, academic research shows that few fund managers can consistently beat the market over the long term. In hindsight, finding a few funds outperforming for three-, five-, or even 10-year periods is easy. The challenge for investors is to identify these outperformers in advance — an impossible task. What often ends up happening is a reversion to the mean, where yesterday’s winners become tomorrow’s losers.
The S&P Dow Jones Indices SPIVA Scorecard shows that in the past five years, 79% of large-cap funds have lagged the S&P 500. Their longer-term track record is even worse: Nearly 88% of large-cap funds have trailed the S&P 500 in the past 15 years.
Which index funds should I choose?
Suppose you’re the type of investor currently investing in your bank’s actively managed mutual funds but don’t have the time or inclination to manage your own portfolio or go with a robo-advisor. In that case, we advise that your bank advisor build you a portfolio of index funds.
TD offers the cheapest set of index funds through its popular e-Series funds. Clients of TD can build a diversified portfolio with just four TD e-Series funds:
TD Index funds
If you’re not a TD customer, then any of the other big bank index funds can also do the trick. All of them offer a suite of index funds to mimic the Canadian, US, international and bond markets. All are better options (as you can see in the comparison chart) than their expensive and actively managed counterparts.
How do I invest in index funds in Canada?
To invest in index funds in Canada, your first step is to open a brokerage account via a financial advisor with a traditional bank with a DIY trading platform, such as Questrade. Once your account is set up, you can decide on your index fund investment strategy by determining which market indexes you want exposure to, such as the S&P/TSX Composite Index for Canadian stocks or the S&P 500 for US stocks. You’ll also need to determine your preferred asset allocation between stocks and bonds. If you don’t feel up to making your own choices or feel intimidated by investing on your own, you can use a robo-investor such as Wealthsimple, which will buy and manage index funds for you.
Index funds vs. index ETF
Index funds are mutual funds that track specific market indexes, such as the S&P 500 or S&P/TSX Composite Index. They’re bought and sold in units at prices set at the end of trading days. An ETF is bought and sold on an exchange, like a stock, during regular trading hours. ETFs can be passive or actively managed, with many tracking the same indexes as index funds.
The best place to buy index ETFs is at a discount brokerage. Also known as an “online broker,” it’s a great option for DIY investors who feel confident building their portfolio and don’t want to pay the high fees attached to actively managed funds. Our top choice is Questrade. With no annual fees or fees for purchasing ETFs, you can build an ETF portfolio for $0, making Questrade one of the lowest-cost options. Use a screener to find all the index mutual funds and ETFs available through your favourite platform.
| QTrade review | Questrade review | Wealthsimple review |
|---|---|---|
|
|
|
| ◦ Commission-free ETFs, stocks, options, mutual finds and more.◦ Fantastic educational resources for beginners and intermediate traders.◦ Attractive sign-up bonuses | ◦ Best online brokerage in Canada◦ Low fees, free ETF purchases◦ Excellent customer service | ◦ No account minimums◦ $0 commission ETF trading◦ Reinvest dividends automatically |
| Invest an ETF Index fund | Invest an ETF Index fund | Invest an ETF Index fund |
Best index fund ETFs for Canadians to invest in
If the DIY route is intimidating and you’re not ready to pick stocks yet, you can invest in stocks with the help of a robo-advisor. Robo-advisors will automatically create a diversified, balanced portfolio based on your preferences, like time horizon and risk tolerance. Plus, they offer fees much lower than a bank or brokerage — saving you even more money in the long run. If you want to compare robo-advisors in Canada head-to-head, read our complete guide to the best robo-advisors in Canada. But here’s the short story: with its low fees, easy-to-use platform and exceptional customer service, Wealthsimple is our top choice for the best robo-advisor in Canada.
In Canada, ETFs typically charge a fraction of what mutual funds cost – and so although index mutual funds are cheaper than actively managed funds, an index-tracking ETF is even more affordable. For example, Vanguard’s FTSE Canada All Cap Index ETF (TSX:VCN), which tracks the entire Canadian market, has an MER of just 0.06%.
Here’s a model portfolio you can use to emulate the Canadian Couch Potato strategy – taking a balanced approach to allocation with 40% bonds and 60% stocks:
Alternatively, you can build an even simpler version of the above portfolio with just one ETF. Vanguard, along with other ETF providers such as iShares and BMO, has introduced something called asset allocation ETFs. These products are essentially balanced ETFs, with a blend of domestic and international stocks and bonds.
Vanguard’s VBAL is a balanced ETF with a 40% allocation to bonds and a 60% allocation to stocks:
Passively invest in the S&P 500 on auto-pilot
Alternatively, all this conversation about different ETFs and funds makes you question investing. But that's the biggest mistake you can make. It's more valuable to start investing as soon as you can because the longer your money is in the market, the faster compound interest can get to work for you.
You don't need fancy tools to read big charts to understand the market. You can get a robo-advisor to do the work for you (though there are some fees). If you want incredibly low MER fees but a monthly flat fee, check out Moka if you're going to invest in the S&P 500 without thinking about anything (except watching your money pile up).
Get started with MokaRELATED: The best ETFs in Canada for young Canadian investors
Index investing amid a financial crisis
One knock against passive investing is that, while it’s great to match the market’s performance during a bull market, it’s not as fun to watch your portfolio drop when the outlook turns bearish. Indeed, index investors like me saw their portfolios take a 20 to 25% hit in a relatively short one-month period during the COVID-19 crisis.
This is why investing with an appropriate asset mix is important for index investors. During financial crises, a well-diversified portfolio with a mix of asset classes can help mitigate losses and provide more stability to help get you through market upheavals. For example, a mix of asset classes might include equities for growth, bonds for stability, and real estate for diversification. This diversified approach helps mitigate risk and can provide more balanced returns during volatile market conditions.
Don’t let the possibility of a turbulent market dissuade you from starting your ETF investing journey. My advice is to think long and hard about your risk tolerance and the type of losses you’d be willing to accept. Find an asset mix that matches your risk profile, and then build your portfolio with an asset allocation ETF or three to four ETFs you can maintain and stick with over the long term.
Is index investing right for you?
While some talented traders can outperform the market, the average investor benefits more from a hands-off approach like index investing. It’s not glamorous, but it’s effective. If you prefer not to monitor your portfolio daily or worry about market swings, index investing is an easy, reliable option to grow your wealth over time.
Are index funds still worth it?
Index funds can be an excellent option for investors who don’t want to actively manage individual stocks. This passive investment strategy is designed to provide broad market exposure and low operating expenses. This form of investing can be especially appealing to a new investor or someone who wants to take a passive role in growing their money because you don’t need to be constantly watching the market and changing investments. Funds are selected for you and align with top-performing funds in global markets. Index funds are also appealing because they offer low MERs, which means you can earn more on your investments over the long term.
Final thoughts
Investors are flocking to index funds for good reason. They offer broad diversification at a low price point – two factors that lead to higher long-term performance. Investors can build a globally diversified portfolio with as few as one fund, or as many as four to five funds. They’re easy to buy and sell through a discount brokerage account online, making them a great fit for DIY investors. Check out our ultimate guide to Canada’s discount brokerages to find one that best suits your needs.
Robb Engen is a leading expert in the personal finance realm of Canada and is also the co-founder of Boomer & Echo, an award-winning personal finance blog.
Sandra MacGregor has been writing about finance and travel for nearly a decade. Her work has appeared in a variety of publications like the New York Times, the UK Telegraph, the Washington Post, Forbes.com and the Toronto Star.
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