Index funds, or passive investing, is an increasingly popular way to access the stock market with less effort, and considerably more profits, than an active approach where stocks are chosen based on their likelihood to outperform.
1. What are index funds?
Index funds invest in a group or index of stocks, bonds, or other assets, meant to represent a certain sector, country or section of the world.
Instead of picking the most attractive stocks and resigning themselves to underperforming the global market over the long term, as shown in a recent report by Index Fund Advisors, investors can buy a low-fee index fund that owns the entire market and spend the saved time on more productive activities. According to an article by Meb Faber, a popular fund manager and financial podcaster, this simple switch has yielded 5 per cent above inflation per year from 1900 to 2018.
For perspective, Canadian inflation averaged 3.15 per cent from 1915 until 2024, while global inflation has averaged between 3 and 5 per cent since 2000. These figures make it reasonable to expect long-term global stock index fund returns in the vicinity of 8 per cent per year.
2. How do index funds compare to active investing?
Research: Active investors will often spend hours combing through balance sheets and income statements, as well as evaluating products and services with the strongest demand, before choosing a stock whose underlying operations seem likely to do better than the global market, or at least the national markets it trades in. Index investors, on the other hand, only need to buy one fund to capture the entire universe of stocks their active counterparts must spend their days parsing through.
Performance: According to data from the S&P Indices Versus Active (SPIVA) report, only 3.37 per cent of active Canadian investment funds outperformed the S&P/TSX Composite Index over the past decade. This means 97 out of 100 professional Canadian investors failed to pick stocks that earned more than simply owning the entire Canadian stock market, which index funds allow you to do.
Fees: The mammoth discrepancy between passive and active performance is mostly because of index funds’ low fees, which can be as low as 0.05 per cent for a fund that tracks the TSX. Active funds, for their part, rely more heavily on research and frequent trading, which entail an average annual fee up to 30 times higher at about 1.5 per cent. Over an investing lifetime, this fee differential can result in hundreds of thousands of dollars being diverted into your investment provider’s pockets, instead of yours.
3. What kind of index funds can you buy?
Stock index funds come in all shapes and sizes, from those that track individual market sectors, like energy or technology, to those that track national markets like Canada or the United States, to those that own tens of thousands of stocks and track the entire global market. You can also invest in indexes that focus on bonds, precious metals, real estate and even cryptocurrency.
Most long-term index investors choose to own one fund that tracks the global stock market, such as Vanguard’s VEQT or Blackrock’s XWD, or a series of funds that track their national stock market, the United States, developed international markets and emerging markets, for added flexibility to more accurately achieve their desired asset allocation.
Your asset allocation is simply the percentage of stocks, bonds and other assets that best position you to meet your financial goals, while remaining in line with your risk tolerance and financial situation. If you’re investing for a goal within the next one to five years, you should favour less volatile investments such as bonds, savings accounts and guaranteed investment certificates to ensure your funds are there when you need them. If your goal is further out than that, a good rule of thumb is to add a 5 per cent stock allocation for every year beyond five years that your goal extends.
4. Who are the best index fund providers?
Canadians can look to familiar names in the realm of finance for their index funds, each of which boasts a multi-generational track record of safe and reliable asset custody. These include:
- Vanguard, the world’s second-largest investment manager at US$7.25 trillion as of March 2023, according to Statista, and the inventor of the first publicly available index fund in the 1970s
- Blackrock, the world’s largest investment manager at US$9.43 trillion as of March 2023
- Canada’s Big Six banks, listed here in order of market capitalization: Royal Bank of Canada, TD, Bank of Montreal, Scotiabank, Canadian Imperial Bank of Commerce and National Bank of Canada
While there will be stark differences among the types of index funds these institutions provide, those that track broad markets, like entire countries, groupings of countries, or the entire world, will be similar enough in construction and annual fee to produce approximately the same returns over the long term. Just make sure to buy index funds in an ETF or exchange-traded fund wrapper, which offers lower fees and better tax efficiency compared with legacy mutual fund wrappers.
5. How should you build your index fund portfolio?
Whether you invest in one or a handful of index funds, research from Morningstar suggests that you should be prepared to hold stocks for at least two decades to give yourself the best chance at satisfactory returns. With that timeframe in mind, you should then consider which account to hold your index funds in:
- A tax-free savings account allows you to keep all of your dividends and capital appreciation without having to pay taxes, subject to yearly contribution limits.
- A registered retirement savings plan (RRSP) allows you to defer taxes on investment gains, again subject to yearly contribution limits, as well as deduct every dollar contributed from your taxable income for the year, or any subsequent year until you turn 71. If you have to use funds from your RRSP, they will be taxed at your income tax rate at the time of withdrawal.
- A non-registered brokerage account, which commonly comes into play after investors run out of RRSP and TFSA room, requires you to pay taxes on dividends and capital gains in the year you receive them. Account holders can offset capital gains with capital losses in any of the three preceding years or in any future year.
Once you’ve identified the investment account best aligned with your financial goals, you can go ahead and buy units of your index fund(s) in line with your asset allocation, just like you would with an individual stock. Simply type in the ticker code, specify the number of desired shares, and set a limit price per share at or one-to-two cents above the current ask price to ensure your order is filled. You can also select a market order to pay whatever price the shares are trading for, which may change from second to second contingent on that day’s volatility.
As you make monthly or bi-weekly contributions, remember to regularly rebalance your portfolio, should any assets grow beyond a percentage you’re comfortable holding.
6. Can active and passive investing coexist?
Even though index funds have trounced active funds in Canada and across the world over the past decade, and in many cases, the decade before that, it’s only fair to play devil’s advocate and say plenty of stocks do better than their national markets. And while it certainly takes more work to identify them compared with buying into a diversified portfolio of index funds, it is far from impossible for investors who know what green flags to look for: such as experienced management, expanding market share, improving asset quality, brand power and growing profits.
Take a look at Founders Metals (TSXV:FDR), Dynacor Group (TSX:DNG) and Alphamin Resources (TSXV:AFM) for three small-cap examples with recent Stockhouse coverage, that have beaten the TSX by 5x, 3.5x and 8x over the past five years, respectively.
More familiar names in the large-cap space, such as Enbridge (TSX:ENB), Brookfield Asset Management (TSX:BM) and Shopify (TSX:SHOP) have done even better, lapping the TSX by more than 20x-40x going back to the mid-1990s.
Individual stock pickers also have distinct advantages compared with professional managers when it comes to making money in the markets. These include the ability to build positions in micro-cap and small-cap stocks that are too small for active funds, which may have hundreds of millions or even billions of dollars to allocate, and the ability to hold prospective stocks through long periods of volatility without suffering from the career risk entailed by managing other people’s money. If we combine these advantages with a solid due diligence process, there is no reason why an active investor shouldn’t be able to yield a decent return.
Will this return be higher than a comparable index fund over an investment lifetime? The data is clear that the answer is probably not. This is why it’s reasonable for investors who can’t resist the allure of active strategies to own a core percentage of their portfolio in index funds, ensuring an average long-term return close to the global market, while pursuing gains above that average with satellite positions in single stocks.
In this way, Stockhouse readers can find a balance between slow-and-steady passive investing, and shooting for the moon with active stock picks, on the road to funding their financial goals.
Join the discussion: Learn what other investors are saying about how to invest in index funds on Stockhouse’s stock forums and message boards.
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