Index Funds

In this post I'm going to discuss a type of "mutual fund" that is fairly popular with more educated and sophisticated investors. Index funds are something that are being discussed more and more in todays investment world, especially by those who are not very fond of traditional mutual funds. In this post I'll compare index funds with traditional mutual funds, and try to give the main differences between the 2.

What are Index Funds?

Essentially, an Index Fund is just a Mutual Fund that tracks a specific Index, such as the S&P/TSX Composite Index (Toronto Stock Exchange). An index fund will try to emulate the returns of the index as much as possible, by holding the same stocks as the index itself, and holding the same weightings as each of the stocks in the index.

An index fund will invest in the largest, strongest, and the best known companies in the country/region (and sometimes sectors or commodities) they are invested in. This might offer investors some sort of 'security' in their investment, in the sense that investors will feel that larger companies are less likely to get into financial trouble or become bankrupt or the like.

Management Style

Whereas a regular Mutual Fund will have a mutual fund manager who will buy and sell securities and try to beat the index (known as either professional or active management - depending on the type of fund), an Index Fund will take on what is known as 'passive management'. This is because the Index Fund Manager does not have to do much buying/selling, and his/her job is just to mimic the index as best as possible. Therefore, this requires a lot less research; which will also reduce the overall cost of the fund.

Having 'passive management' means generally there will be no advice from advisors as you would get with traditional mutual funds (therefore no trailer fees paid to the advisor -- which keeps their cost lower). This is why generally Index Funds are used by more sophisticated and educated investors.

Many Index Funds will not be able to fully mimic the index because they will have a 'weighted cap'. This means the fund will not be allowed to have more than x% of one company. For example, at one point Nortel made up more than 35% of Toronto's Stock Exchange, but when it crashed, it took the S&P/TSX Composite down with it. So to reduce the market risk, most Index Funds will have a 'cap' on how much % they can have of one company.

Costs

Since the management of an Index Fund requires a lot less in the way of research, buying/selling, management etc..., this will greatly reduce the costs (MERs) associated with the fund. Where a regular mutual fund can range from about 1.5% to 2.5%, an average Index fund can go anywhere between about 0.4% to 1.4% (depending on the company and the index it is following).

Also, Index Funds are generally bought from on online trading platform or a discount brokerage. This means for every transaction (buy or sell), there would be a charge. Depending on how many transactions are done and how much each transaction is for, this could actually negate any savings from the lower MER. In some cases, the fees associated with trading online will be more than an MER on a regular mutual fund, and thus lowering the overall return of the fund, thus

Risk/Returns

Although an Index Fund will hold the strongest, largest and best known companies in the country/region, they still carry risk (as does any other fund). In fact, often, an Index Fund will have more risk than an average Mutual Fund Portfolio. This is because an Index Fund will track only the Index in a specific region, so it will not give as much diversification as many Mutual Fund Portfolios.

Some will say to balance out risk, to just buy several Index Funds from several different Regions/countries, so to reduce the risk, but that availability of Index Funds for other regions is not as much as for regular Mutual Funds. Regular Mutual Fund portfolios generally have the ability to diversify more than an Index Fund Portfolios, so to reduce the risk. Also, as mentioned above, often there will be a small percentage of companies making up a large percentage of the index, and therefore will make up a large percentage of the Index Fund. This will be more risky than most Mutual Funds, who will have more companies with less weighting, so to spread the risk out.

Generally, Index Funds will have higher returns over a longer period of time, as compared to the average Mutual Fund. Having said that, the volatility is still a lot higher than Mutual Fund portfolios. A Mutual Fund manager will try to match, or even beat the index, with using as little risk as possible. So, although the general returns for Index Funds are higher than the average Mutual Fund, this is not considering the risk involved. If we were to look at the "risk-adjusted returns" (the returns calculating the risk being taken) for Index Fund in comparison to average Mutual Funds, we would find the the returns would actually be fairly similar.

As mentioned before, there is no "one-size fits all" investment or strategy for everybody. Index Funds can be a great addition to an investment portfolio, but only if used properly. Please consult your financial advisor before making any decisions on using Index Funds in your portfolio, and also do your own homework.

I hope you have learned something from this post, and please don't hesitate to contact me if you have any questions!