Many new traders find that picking individual stocks is a daunting task.
Researching the company, its financial performance, earnings reports, management team, and strategic plans are just some of the many steps traders will take before deciding whether or not a stock is worth investing into.
Even after all that effort, there is no guarantee the stock you choose is a good one.
Sometimes, all it takes is one bad news event to send the stock tumbling.
Even worse, a scandal or bankruptcy like the Enron Scandal could mean that the company’s stock drops to pennies and your money can never be recovered.
This is made even more dangerous when traders decide to put all their eggs into one basket.
While some companies may seem too big to fail now, there is no such thing in the market as a risk-free investment.
To reduce the risk inherent in picking individual stocks, index funds are a great alternative.
The goal of index funds is to mirror the performance of the market they track as a whole.
For example, if the S&P 500 goes up 2 percent a day, an index fund that tracks the S&P will also go up 2 percent.
Rather than investing in all 500 companies that comprise of the S&P 500 individually, index funds give traders a much easier way to invest in the markets that they are interested in.
These index funds are listed on exchanges and can be purchased just like any other stock.
All you need to do is find the ticker of the index fund you are interested in and make your purchase.
This easy process makes index funds an appealing option to individuals interested in a more passive investing style.
Did You Know?
Even the world’s most successful investor, Warren Buffet, recommends that everyone hold index funds in their portfolio.
In an interview, Buffet stated that “A low-cost index fund is the most sensible equity investment for the great majority of investors.”
Index funds are often compared to Exchange Traded Funds (ETFs), and the terms are sometimes used interchangeably.
The two share many similarities, but one important difference is that index funds are usually not actively managed.
This means that there is no fund manager responsible for picking out new companies to add or remove from the index fund.
In contrast, some ETFs are actively managed, meaning there are professionals who are in charge of the index with the goal of generating a higher return.
Depending on the type, some ETFs can even be rebalanced daily.
As a result of this passive investment, index funds generally have lower management fees and operating costs (known as Management Expense Ratios, or MERs) than actively managed ETFs.
While index funds are inherently safer than picking individual stocks, investors will still have the ability to make decisions based on their risk tolerance.
For example, an index fund that tracks U.S.-based markets will be seen as much more stable than an index fund that tracks emerging markets.
What are the Best Index Funds for Canadians?
When deciding what types of index funds to include in your portfolio, several factors need to be considered.
The first is the index itself.
Major indices like the S&P 500, the NASDAQ Composite, the Dow Jones Industrial Average, the S&P/TSX Composite Index, and the Russell 2000 all have multiple funds that track the same index.
It is important to check that the fund you have selected is successfully tracking the underlying index it is meant to mimic.
Additionally, it is important to check the MER of the index fund you want to purchase.
While the difference between them is probably less than one percentage point, MERs can quickly add up, especially when holding stocks over decades.
To illustrate let’s imagine an individual investing $5,000 into an index fund every year for 25 years at an average return of 7 percent.
At the end of the 25 years, an individual who invested their money into an index fund with a MER of 0.25% will save $40,265.34 over someone who picked an index fund with a MER of 1.25%.
Finally, another aspect to consider is diversification.
While index funds are already highly diversified by nature, ensuring that you have exposure to markets around the world can provide safety in times of uncertainty.
With these factors in mind, here are some of the top index funds for Canadians to invest in.
|Index Fund||Ticker||MER||1-year return||5-year return|
|SPDR S&P 500 ETF Trust||SPY||0.0945%||31.04%||113.19%|
|Invesco QQQ Trust Series 1||QQQ||0.2%||31.38%||219.5%|
|BMO NASDAQ 100 Equity Hedged to CAD Index ETF1||ZQQ||0.39%||30.63%||199.26%|
|Vanguard S&P 500 ETF||VOO||0.03%||31.15%||113.49%|
|Vanguard S&P 500 Index ETF||VFV||0.08%||23.55%||97.31%|
|iShares Russell 3000 ETF||IWV||0.20%||32.36%||107.24%|
How to Buy Index Funds in Canada
1. Choose an index fund(s)
Picking the correct index fund can be difficult.
For indices such as the S&P 500, there can be upwards of a dozen different index funds run by different investment management companies like Vanguard, Invesco, or BlackRock.
Each company offers a very similar product and all aim to mimic the results of the underlying market (i.e., the S&P 500) as much as possible.
To differentiate, factors that may need to be considered are things like the liquidity of the index fund, historical returns, and the MER.
As a Canadian, another thing to consider is to check whether the index fund is “hedged” to the Canadian dollar.
This only applies on indices that hold U.S. stocks, but trade in Canadian dollars.
In these cases, purchasing a hedged index fund means that changes in the price only reflect changes in the underlying index it is tracking, and prices are not impacted by changes to the exchange rate.
On the other hand, unhedged index funds take into account both exchange rates, as well as changes to the underlying index being tracked.
Since many choose to hold index funds for the long term, these seemingly little factors can make a big difference over decades.
Aside from these factors, personal preference also will help guide your decision.
Make sure to select the best index fund that helps you meet your own investing goals and risk appetite.
2. Determine which investment platform to use:
Once you have settled on the index fund or funds you would like to invest in, the next step is to choose an investment platform.
As mentioned, index funds trade on the stock market just like any individual company.
Once you select one, fund your account, search the ticker on your trading platform, and make a purchase – just like you would with any other regular stock.
Canadian investment platforms like Wealthsimple allow for most index funds listed on Canadian exchanges like the Toronto Stock Exchange like ZQQ and VFV to be bought and sold at no cost.
In contrast, purchasing any index funds listed on U.S. exchanges may have additional commissions or fees associated with them.
In addition to looking at MER, Canadians must also consider the commissions and fees that investment platforms charge for purchasing index funds listed on American markets and factor them into their calculations when making a decision.
3. Purchase your desired index fund: After picking a platform and an index fund, you are ready to make your purchase.
Just like with any other stock, each index fund will have a ticker that can be searched.
Make sure you have funds in your account and then you are all set.
Some people like to add a little bit to their holdings periodically, while others want to lump sum and purchase all at once.
Personal factors such as income and other expenses all come into account, and there is no one right way to invest your money in index funds.
If possible, it is a good idea to set aside a bit of money each month to add to your portfolio.
This technique, referred to as dollar-cost averaging, is a great way to systematically invest and avoid the impacts of any potential volatility.
Pros of Investing in Index Funds
One of the main reasons investors choose to hold index funds rather than individual stocks is the lower risk associated with them.
The broader market index funds are protected from sudden price drops that might occur on individual stocks due to poor earnings reports or other news.
Rather than having all the eggs in one basket, index funds allow for a more steady approach to investing.
Index funds are a great way to take a long-term approach to investing.
Rather than focusing on short-term price fluctuations, index fund investors look at the long-term growth of the entire market.
Over the past several decades, historical returns have shown that index funds continue to grow at a steady pace.
While you won’t see massive profits overnight, index funds will give you a great chance of steady long-term growth.
Using techniques like dollar cost averaging, index funds are a great “set it and forget it” strategy for investors.
No need to research:
With index funds, there is little need to research individual companies and spend hours deciding where to place your money.
Index funds are designed to spread your money amongst hundreds or sometimes thousands of companies, taking out the stress of picking winners in a crowded marketplace.
For this reason, index funds are often recommended for newer investors or those who have less time to commit to investing.
Cons of Investing in Index Funds
Having less risk is one of the greatest benefits of index funds.
However, the flip side of that is the fact that investors may miss out on big gains on individual names.
Hearing news about a stock going up 50, 60, or even 90 percent in a day may lead to a fear of missing out (FOMO) syndrome in index fund investors.
While riskier, successfully picking individual names that break out will yield greater returns than index fund investing.
However, the long-term success of index fund investing is hard to replicate through individual stock trading.
No flexibility during downturns:
As the main goal of index funds is to mimic the performance of the index it is trying to track, the fund managers have little flexibility when the stock market is performing poorly.
While actively managed ETFs are able to react to economic shocks and market downturns, index funds are forced to continue following the market down.
This can lead to losses in the short term.
While this is not an issue for long-term investors, emergency situations where access to money is needed can arise at any time.
Seeing account balances drop during an economic downturn can be a very stressful situation.
Investing in index funds can sometimes make you miss out on opportunities.
For example, indices that track the S&P 500 only provide exposure to the 500 largest companies in the United States.
This means that you are limiting yourself and losing the chance to hold small-cap stocks in your portfolio.
Investors may need to look for more niche or specific funds if they want to gain exposure to less traditional indices.
Lack of control over portfolio:
While index funds may generate returns an investor is looking for, the downside is that you are not given the opportunity to choose what is being held in your portfolio.
For example, if an investor does not want to hold a specific company for moral reasons (e.g., tobacco, oil and gas companies), they are limited in their options.
As these large corporations are a part of many index funds, those who want to exercise personal choice have limited options.
Frequently Asked Questions
- How do I buy an S&P 500 index fund in Canada?
Several different financial institutions have created index funds that track the S&P 500. Depending on who created the fund, they may be listed on either Canadian or American exchanges. As Canadians, most brokerages offer the ability to buy and sell on exchanges in both countries. However, there are several brokerages that offer free trading on Canadian exchanges while charging commissions on US-based ones. These fees need to be taken into consideration when deciding which S&P 500 index fund to purchase. Two examples are VOO (listed on the NYSE) and VFV (listed on the TSX).
- Can you buy index funds in Canada?
Yes, Canadians have access to hundreds of different index funds. These funds may track indices in Canada, the United States, or other countries and regions around the world. To purchase, Canadians just need to sign up with any brokerage platform and create an account. From there, it is as simple as buying any other stock. These index funds can be held in just about any account that regular stocks can be held in. This includes registered accounts like the RRSP or the TFSA, making index funds a great choice for those interested in saving for retirement.
- What is a good MER for an index fund?
In general, index funds are not actively managed. This means that there is no fund manager buying and selling stocks constantly within the fund. As a result of this, the MER for index funds is usually much lower than other actively managed funds. Investors should be looking for funds with MERs as low as possible, in order to maintain as much of the profits as they can. While actively managed funds can have a MER upwards of 2%, passively managed index funds should not have a MER that goes over 0.5%.
- Do index funds pay dividends?
Yes, many of the major index funds do pay dividends. As some of the companies held in the index fund pay out dividends, these are passed through the index fund to the investor. However, these are usually in the low 1-2 percent range. For those interested in specifically seeking out dividends, there are actually index funds built for that. Funds like the Dow Jones Select Dividend Index Fund and The Vanguard High Dividend Yield Index Admiral Shares (VHYAX) track indices such as the FTSE High Dividend Yield Index. These index funds are a great way to accumulate dividends in your portfolio.