What an index fund is
An index is a list of companies chosen by a rule. The S&P/TSX Composite follows most of the larger companies on the Toronto Stock Exchange, the S&P/TSX 60 the 60 biggest, and the S&P 500 500 large US companies. An index fund, or an index ETF (exchange-traded fund, which you buy and sell on the stock exchange like a share), simply buys every company on the list, in proportion to its size. Nobody picks winners, so it’s cheap to run.
Why it usually wins
- You get the market’s return, less a small fee. Some companies soar and some fail, but you own all of them.
- It’s spread out. One company cutting its dividend or going bust barely moves a broad index fund.
- It’s cheap. Broad index ETFs listed in Canada often have an MER (management expense ratio) of 0.05% to 0.25%. Many actively managed Canadian mutual funds charge 1.5% to 2% or more, and part of that can be a trailing commission paid to the adviser who sold it.
- Most stock pickers fall behind. S&P’s SPIVA Canada reports have found, year after year, that most actively managed Canadian equity funds do worse than the S&P/TSX Composite over 10 years or more.
What fees cost you
$10,000 invested for 30 years, growing 7% a year before fees:
| Yearly fee | After 30 years |
|---|---|
| 0.1% | $74,017 |
| 1% | $57,435 |
| Difference | $16,582 |
The fee comes out every year, and so does the growth it would have earned. Compare a fund’s MER in its Fund Facts or ETF Facts document, which every fund sold in Canada must publish. The compound interest calculator shows growth with your own figures.
Over 30 years, a 1% fee costs you
$16,582
- You keep (1% fee)$57,435
- Lost to the higher fee$16,582
Assumes a 7% return every year before fees. Real returns vary, but fees come out every year.
Don’t keep it all in Canada
Canada makes up only a small share of the world’s stock markets, and the TSX leans heavily on banks, energy and mining. A fund holding only Canadian shares misses most of the world’s technology, health care and consumer companies. That’s why many Canadians use an all-in-one ETF, which holds Canadian, US and international stocks, and often bonds, in one fund and rebalances for you.
Picking your own stocks
It can be fun, and some people do well, but:
- A handful of stocks is risky: one bad result can wipe out years of gains.
- Trading costs and tax add up if you buy and sell often. In a non-registered account, half of each gain is taxed, and the superficial loss rule can deny a loss if you buy the same shares back within 30 days.
- It’s hard to tell skill from luck over a few years.
If you want to try, keep it to a small share of your money, and the rest in index funds.
How to start
- Pick the account first: a TFSA, RRSP or FHSA, so the growth isn’t taxed each year.
- Open it at a discount brokerage, where many ETF trades are free, or with a robo-adviser, which builds an index portfolio for a slightly higher fee.
- Choose one broad, low-cost ETF, such as an all-in-one fund that matches how much risk you can take.
- Set up an automatic contribution, and leave it alone.
Invest money you won’t need for at least 5 years, and keep going when markets fall: selling in a panic turns a temporary fall into a real loss. Start with investing basics if you’re new.