If you’ve been following the gospel of investment diversification, then you’ve probably come across index funds. An index fund is a type of mutual fund (or an ETF) that’s meant to be a miniature copy of an established market index, such as the S&P/TSX Composite or the Dow Jones Industrial Average. This means that an index fund includes fractional shares of all components of a particular index and mirrors that market’s performance.
Index funds are popular among investors who take a more passive approach to investing and are more focused on a market’s long-term growth. Because an index fund gives you access to all the stocks within a single market, portfolio diversification is built right in.
1. Know which market index you want to draw from
Index funds mirror specific market indexes, so you have a variety of options. Do you want to invest in an S&P/TSX index, where you’ll have access to 225 large Canadian companies? Or the S&P 500, which is the U.S. equivalent and covers the 500 largest publicly traded U.S. companies across a wide variety of industries? Or maybe you want to go international and look at the MSCI World Index, which covers 23 different countries?
2. Decide how you’ll buy your funds
You’re going to need to go through an investment platform or a brokerage. There are a huge number of investing platforms you can choose from online, depending on how involved you want to be in the whole process. With some platforms, you determine when to buy and sell, whether you want to manage it yourself or have investments managed for you, and at what frequency you’ll be investing. Also keep in mind that this means your fees will vary — more service equals more fees, naturally.
3. Compare costs
The costs of investing in index funds will depend on what investment platform you choose. Some accounts will have pretty steep account minimums, while others might have higher investment minimums. Also keep an eye out for any commissions, transaction fees, and service fees.
Should I invest in index funds?
Index funds aren’t a great fit for every investor; it all depends on your personal goals, style, and comfort level.
One of the big pros of index funds is low cost. Because they mirror the market they’re picked from, index funds don’t require a super-involved manager who’s constantly trying to stay ahead of the market, selling and picking new stocks. The stocks have already been picked out for you by the market. There are also lower transaction costs because you’re not picking, choosing, and trading individual stocks from within the market. Maintaining a portfolio of index funds will usually run you 0.05% to 0.25% annually, while actively managed funds can charge 1% to 2%.
Another benefit is the fact that index funds allow investors to participate in the long-term growth potential of a particular stock market, with a caveat: not all markets and not all index funds are created equal. It’s important to ensure that the market you choose has a reliable track record of long-term returns.
The key word here is “long-term.” Since your investments will be mirroring an index, it’s natural that there will be ups and downs in the short-term.
Historically, big markets have provided steady returns for patient investors who don’t spend too much time fiddling about with their portfolio, and experts like Warren Buffett himself have argued that index funds will usually outperform actively managed funds in the long run. The average annualized total return for the S&P 500 over the past 90 years has been more than 10%! Past performance, of course, is no guarantee of future results, but that still sounds pretty good.
So what’s the downside? Well, if you want to have control over your individual holdings and invest more heavily in one sector of a market, such as technology, you’ll be frustrated with index funds, since they mirror the market as it stands. Index funds are set portfolios, and you can’t really change their content. For some investors, it’s important to have the freedom to act if they see a certain sector of the market being over- or undervalued.
How many index funds should I invest in?
Because an index fund covers an entire market sector, it comes with some diversification built in. The more index funds you buy, the more diversified your portfolio should be.
Of course, you can always enhance your assets with the aid of a robo-advisor, which can help spread your money across more sectors with the help of ETFs, which can cover stocks, bonds, real estate, and international markets. That way, you’re not just stuck in one market and can diversify even further.
