Do you want to know how to invest in index funds? It doesn’t matter if you’re a new investor or approaching retirement, index investing is a strategy that works for anyone. Even Warren Buffett recommends index funds for the average investor. What makes it so appealing is that there’s minimal work required on your end and the fees you’ll pay can be quite low. That means you’ll end up with more money in your pockets. A lot more money. Like, tens or possibly hundreds of thousands of dollars more.
While it’s true that index funds will only give you average returns, the reality is that 90% of actively managed funds don’t outperform similar indexes. By taking the passive approach with index funds, you’re accepting average returns, but at a much lower cost. The difference in the management fee is often huge when you compound it over your investing lifetime. Here’s how to invest in index funds.
- What is an index fund?
- What is an index fund vs. a mutual fund?
- How the management expense ratio affects your return
- Understand your investor profile
- How to invest in index funds
- Which index fund should I invest in?
- Do index funds give dividends?
- Can you lose money in an index fund?
- Final thoughts
What is an index fund?
Before getting into the details about how to invest in index funds, you’ll want to know what is an index fund. Think of index funds as a type of mutual fund or exchange traded fund that’s designed to track a specific stock market index. Some of the most common indexes include:
- S&P/TSX Composite Index (The benchmark index in Canada)
- S&P 500 Index (The benchmark index in the United States)
- Dow Jones Industrial Average (DJIA – tracks the largest 30 companies in the U.S.)
- Nasdaq Composite (Tracks 3,000+ technology companies)
- MSCI EAFE (Tracks stocks from countries outside of Canada and the U.S. including Europe, Australia, and the far east)
Index funds are passive which means the portfolio manager isn’t making any decisions based on gut or emotion. The index is really just an algorithm that’s meant to mirror the market. If the markets are up, index funds are up. If the markets go down, so do index funds. You’re getting average returns which have been relatively decent since the stock market has opened to the public.
Since index funds are a collection of many stocks, you don’t need to worry about picking individual stocks. More importantly, you’re not required to do any research. Index funds rebalance themselves based on market conditions, so there’s no need for you to worry about anything. Once you have your index funds portfolio, you can sit back and relax. Taking the passive approach can balance your own risk profile as well as any fluctuations in the market.
What is an index fund vs. a mutual fund?
Okay, so I’ve explained what index funds are, but I also said they’re a type of mutual fund. You’re probably still wondering what is an index fund vs. a mutual fund? There are two major differences when it comes to mutual funds: active management and fees
The majority of mutual funds are actively managed. That means a portfolio manager is actively looking at the markets and making decisions based on what’s happening. While this may sound like a good thing since managers are able to gauge what’s going on in the world and make immediate changes to the funds, it rarely works out in their favour. Historically, about 80% of passive funds outperform actively managed funds (That’s a rough estimate).
Sure, 20% of the funds will beat passive funds, but the odds of you choosing those ones are rare. Why’s that? Because most people who sell mutual funds will recommend funds that have performed historically well. The thing is, past performance is not indicative of future results. You might choose a fund that outperforms the index this year, but it might not the next year. Going with index funds can be a bit boring, but accepting average results is not a bad thing.
Management expense ratio
The management expense ratio (MER) is the other major difference when looking at index funds vs. mutual funds. Generally speaking, mutual funds have an MER between 2% – 2.5%. Index funds traditionally charge .20% – .50% (although there are some that charge more). That may not seem like a huge difference, but think about it over your investing lifetime. You’d be giving up tens of thousands of dollars.
For example, let’s say you have $100,000 invested. A mutual fund with a 2.5% MER would cost you $2,500 a year. An index fund with an MER of .25% would only cost you $250. This is per year! The increased fee cuts into your profit margins. Now think about the costs of a larger portfolio. If you had $1,000,000 invested in mutual funds, you’d be paying $25,000 a year. Some people may think they’ll never have a million dollars saved, but after working 20-30 years, it’s totally achievable.
Anyone who works at a bank will try to sell you on actively managed mutual funds since that’s what makes their employer (and sometimes them) the most money, but it’s rarely the best decision for you. Index funds have such a good track record that some mutual funds track indexes, but they still charge you the higher MER.
Note that if you choose to use a robo advisor, they charge an additional management fee which averages about .50%. When you combine that with the fund MER, you’ll still pay less than .80%, so you’re saving quite a bit.
Avoiding high fees should be something you aim for when investing. Think about, let’s say the stock market index returned 7% for the year, but you’ve invested in a mutual fund that charges a 2.30% MER. That mutual would need to outperform the market by about 2% just to match an index fund. The odds of that happening are low. Don’t let fees destroy your returns, go the passive route with index funds.
How the management expense ratio affects your return
If you’re still on the fence about how fees affect your portfolio, let’s take a look at how some mutual funds compare to index funds. I’ve purposely chosen big bank funds so it’s a fair assessment. In fact, these funds are pretty much identical, but one is classified as a mutual fund and the other is an index fund. The performance difference from March 2011 – March 2021 will likely shock you.
|Fund name||10-year annual |
|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|
As you can see, in every scenario, index funds outperform mutual funds. It’s worth noting that I purposely compared bank index funds to their equivalent mutual funds so it’s a fair assessment. What you may have noticed is that only TD and RBC have a relatively low MER. If you were to use an exchange traded fund (ETF), your MER would likely be much lower. For reference, I use Vanguard All-Equity ETF Portfolio (VEQT) and it has an MER of just .25%.
It’s absolutely ridiculous that financial institutions try to convince investors that you shouldn’t settle for average returns with index funds. They also try to convince you that you’re getting human interaction. Well, guess what? I spent about 12 years working with actively managed funds and they didn’t outperform the index. I’d argue I was in an even worse spot because the “financial advisors” I worked with really didn’t know what they were doing. The mutual funds they chose for me did not make any sense for my profile. Of course, I didn’t realize that was the case at the time because I trusted them.
Switching to index funds was the best decision I ever made. Not only did I reduce my fees and increase my returns, but I also learned how to manage my own finances. If I can do it, so can you!
Understand your investor profile
Before I get into how to invest in index funds, I need to talk about your investor profile as this will affect your investment strategy. When you invest, there are two types of assets you need to consider: fixed income and equities.
Fixed income investments are things such as bonds, term deposits, and money market funds. It’s highly unlikely they’ll go down in value, but as a result, the returns are quite low. Equities include stocks and are considered riskier, but they can also give you a higher return. Finding the right balance between the two is one of the core principles of investing and is known as your asset allocation.
Someone who’s in their early 20’s can afford to take more risks because they won’t need the money until they retire. However, if they plan on buying a home in the next five years, they should keep their money in fixed income since they likely don’t want to lose their down payment.
Understandably, some people who are new to investing don’t want to take many risks, so they may be tempted to stick to fixed income investments. That may not be practical since fixed income only returns about 2% a year and inflation is typically higher than that. You need to have some fixed income in your portfolio.
Traditionally, many advisors recommend that you use your age to determine how much fixed income you have. So if you’re 30, you should have a portfolio that’s 30% fixed income and 70% equities. I personally think that’s a bit outdated. I turn 42 this year, and I only have 20% dedicated to fixed income in my retirement account.
I should also mention that many people say they have an appetite for risk, but they panic when markets drop. You’ll have no idea how you really feel about your portfolio until you see it drop 25% – 40% in a month. If that happens and you stay the course, then you’re good.
How to invest in index funds
Okay, you’re ready to get started. But you still want to know how to invest in index funds. It’s actually pretty simple as there are three ways to go about it.
- Use Tangerine’s investment funds or global ETF portfolios
- Use a robo advisor
- Go the do-it-yourself route with a discount brokerage
Which option you choose depends on your comfort zone, but understand that you can always make a switch later. I started with Tangerine index funds before I switched to TD e-series funds. I eventually went the DIY route since it was the cheapest way to invest.
Keep in mind that there were no robo advisors when I started investing, so I had fewer choices. These days, there are so many tools to get you started regardless of how much money you have. Here’s a quick look at your options.
Tangerine has two index fund options: Investment funds and global ETF portfolios. There are five different investment funds that are suitable for different investor profiles. All of the funds have a management and admin fee of 1.07%. The global ETF portfolios are relatively new, so there are only three choices, but they have a management and admin fee of .77%. Clearly choosing the cheaper option in the Global ETFs is better, but this assumes there’s a portfolio that fits your investment profile.
Like robo advisors, Tangerine’s funds are fully automated so there’s nothing for you to do. The .77% fee you pay covers the MER and admin costs, you don’t pay any brokerage fees whenever you invest. Overall, Tangerine is a good solution for people who already bank with them and want to keep their money with a single financial institution. The fees you pay are similar to robo advisors, so they’re a great way to start investing. Note that you must have a Tangerine account to invest with them.
Robo advisors are arguably the best of both worlds. They mainly use algorithms for their investment decisions, but there are still real people behind the scenes that are available to customers. When you set up an account, you’ll be asked a series of questions. Based on your answers, you’ll be recommended a portfolio.
The major advantage of robo advisors is that you have many more options. Not only are there multiple robo advisors, but most of them have a variety of portfolios. Some robo advisors have portfolios that focus on responsible investing, while others are great if you’re opening a Registered Education Savings Plan. When it comes to fees, all robo advisors charge about the same (.40 – .80ish), so you should pick one that best suits your needs.
If you’re new to investing and don’t have any brand loyalty, then going with a robo advisor is the way to go. Some of them even offer some sweet incentives when you sign up. Here are some of my favourite robo advisors:
- Justwealth – Get up to $500 when you join
- Wealthsimple – Get $50 when you join
- CI Direct Investing – Get $10,000 managed free for a year
- RBC InvestEase – Good if you already bank with RBC
- Nest Wealth – Lowest fees for high net worth individuals
Do-it-yourself / discount brokerage
While doing things on your own may sound a bit intimidating, you may already be ready after reading this article. There are many all-in-one ETFs that you can purchase on your own. These ETFs are used by robo advisors, so you’re cutting out the middleman, which saves you about .50% in management fees. The advantage here is that you’re lowering your overall costs.
As a DIY investor, you only pay the MER and any brokerage fees. I personally only make about two purchases a year, so my fees are just $20 ($10 a trade) a year with TD Direct Investing. Other discount brokerages charge similar fees, so you really can’t go wrong regardless of who you sign up with. If you’re making monthly contributions, using Questrade is your best bet since they allow you to purchase ETFs at no cost. You only pay when you sell.
All-in-one ETFs also rebalance themselves, so there’s really no maintenance on your end. Just choose an ETF that makes sense for you. As in, look for one that has an asset allocation that fits your investor profile. Some of the most popular all-in-one ETFs include
- VEQT – 100% in equities (good for investors with a long time frame)
- VGRO – 80% equities, 20% fixed income (arguably the best choice for new investors)
- VBAL – 60% equities, 40% fixed income (a solid pick for those looking for less risks)
Which index fund should I invest in?
Generally speaking, many new investors go with VGRO. This is a balanced ETF that has an 80% equities and 20% fixed income mix. It’s a good balance for most people. You can literally just keep buying VGRO and not have to worry about anything else for some time.
That said, there are a few things to consider. As you know, your risk tolerance and time frame should also factor into your decision. Someone in their early 20s could start with VEQT if they’re sure they can stomach any market drops. For those closer to retirement, going with VBAL is beneficial since it has more fixed income.
You also need to think about your personal situation. Let’s say you have a defined benefit pension through your employer. That acts like one giant bond, so you could go 100% equities (VEQT) when investing since you’d still have guaranteed money when you retire.
I use VEQT in my TFSA since I consider that a long term account and have no intentions of withdrawing from it. However, in my RRSP and taxable trading account, I use VGRO. These choices make the most sense for my investment style and risk tolerance.
Even though there are multiple companies that provide all-in-one ETFs, it’s best to not overthink things. Just choose one and start investing. Try to avoid getting creative by choosing multiple ETFs (especially niche ones) as part of your portfolio. If you’re still feeling a bit overwhelmed, check out Boomer and Echo’s post on the top ETFs and model portfolios.
Do index funds give dividends?
ETFs do pay dividends. If you’re unfamiliar with dividends, it’s what companies pay shareholders. Since ETFs hold many shares, you would get paid dividends. The dividend payout differs for each ETF, but they can be monthly, quarterly, or annually.
If you’re using Tangerine or a robo advisor, those dividends are automatically reinvested. However, if you’re using a discount brokerage, you’ll need to set up your account with a dividend reinvestment plan (DRIP). This is pretty simple as all you need to do is call in and tell customer service to set your account to DRIP.
Note that when doing this, you should ask them to DRIP all your accounts AND all purchases. Some discount brokerages are weird. Even though your account may be set up to DRIP, it may not automatically do it when you purchase a new ETF.
Reinvesting your dividends is beneficial since you don’t pay any brokerage fees even though you’re buying more shares. Plus, by reinvesting any dividends, you’re letting your investments compound. That will just further grow your portfolio.
Can you lose money in an index fund?
Like any other investment, index funds can go down in value. However, since index funds track hundreds of different stocks, if one drops, it’ll have very little effect on your portfolio. There will be times where ETFs drop in value by 10%+, but that’s normal and arguably a good thing.
Think of it this way, when prices drop, you can buy them on sale. When they eventually go back up in price, you’ll see some big gains. Most investors will typically buy high and sell low because they’re emotionally wired to do so.
Think about the latest investment trends. That could be cryptocurrency, Gamestock, weed stocks or anything else. By the time you’ve heard about them, they’re probably overvalued. As soon as they lose value, inexperienced investors sell. That’s not a good long-term strategy.
If you stick to index funds, you’ll “only” get average returns, but you also won’t need to track your portfolio constantly. Just set up some automatic purchases, and forget about it.
Index funds may be boring, but it’s a solid strategy for anyone new to investing. It’s also great for experienced investors since it requires minimal work. With the availability of robo advisors and all-in-one ETFs, you can literally get started in just a few minutes. Start index investing now, and you could save thousands of dollars.