An index fund is a portfolio of several different investments designed to match or track a specified financial market index.
This can include the market as a whole or a specific sector or industry.
Due to the lower investment risk, index funds tend to be the dominant holdings in retirement portfolios and are considered a savings haven by renowned investor Warren Buffet.
1. Choose an Index Fund(s)
Picking the correct index fund can be difficult.
For indices such as the S&P 500, there are more than a dozen different index funds run by different investment management companies like Vanguard, Invesco, and BlackRock.
Each company offers a very similar product and all aim to mimic the results of the underlying market (S&P 500) as much as possible.
To differentiate, factors to consider 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.
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 in the exchange rate.
On the other hand, unhedged index funds consider 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 will also 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 and fund your account, you can 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 (such as ZQQ and VFV) to be bought and sold at no cost.
In contrast, purchasing any index funds listed on US exchanges may have additional commissions or fees associated with them.
In addition to looking at MER (management expense ratio), Canadians must also consider these 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. Considerations When Purchasing an Index Fund
Before selecting an index fund to invest in, it’s important to consider a few things:
It’s important to evaluate what your investment goals are.
If you want to take an active approach to investing with riskier, short-term investments, index funds may not be the best type of investment for you.
They are more for the long-term investor who wants a more hands-off approach to investing with lower risk.
When most people invest, they look at historical averages, but just because something has happened in the past doesn’t mean it will happen again.
The world is a constantly evolving and changing and it’s important to assess the risk for periods that are short, medium and long.
For example, what is an acceptable return for a three-year period? A five-year period? A ten-year period? If the market crashes right before the three-year mark, can you weather the storm until it bounces back at the five-year mark?
MER (Management Expense Ratio)
While the MER on some funds is quite low, take the Vanguard VSP S&P 500 Index ETF (CAD hedged) at 0.09%, there are also many Canadian bank index funds with a much higher MER.
While even 0.5% doesn’t seem like much, over a long period of time this is money that is not being reinvested each year, so it’s important to ensure you’re getting value for the MER being charged.
If you’re planning large expenses in the near future or don’t have a separate emergency fund set up, keep in mind that index funds usually see their best returns over a long period of time.
If you may have needs for the funds in the near future, you may actually lose on your investments if you’re in a rush to cash them out.
4. Purchase Your Desired Index Fund
After picking a platform and an index fund, you are ready to make your purchase.
Transfer funds into your account through the platform, and happy investing! Just like with any other stock, each index fund will have a ticker that can be searched.
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, but there is no one right way to invest your money in index funds.
If possible, budget a little 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.