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But how do they work and what makes them different to other kinds of funds? This guide cuts through the financial jargon to cover everything you need to know about index funds in Canada and why they’re creating so much buzz.
What's in this guide?
- How to start investing
- Compare online trading platforms to access index funds
- What are index funds?
- What is a stock market index?
- How do index funds work?
- The difference between ETFs and traditional index funds
- Why invest in an index fund?
- What are the benefits of investing in an index fund?
- What are the risks of index funds?
- Popular index funds and ETFs available in Canada
- Steps to invest an index fund
How to start investing
If you already understand what index funds are and want to start investing, you can do so through a fund manager, a full service broker or an online share trading platform. One of the easiest and cheapest ways to access index funds is via exchange traded funds (ETFs) which are traded on the Toronto Stock Exchange (TSX).
Before you do so, you should know that not all ETFs are index funds and some funds are riskier than others – you can read more about this below. Ready to invest? The following table shows some of the share trading platforms you can use to access index funds.
A typical managed investment fund is a portfolio of stocks and other assets. Instead of buying shares in one company, you can invest in a bundle of them. To deliver profits for their clients, fund managers buy and sell assets within the fund by trying to predict market movements. This difficult feat is known as “active” management.
An index fund is handled a little differently. It’s simply a pool of company stocks that mimics a financial index, requiring little intervention from its fund managers.
To understand an index fund, it’s important to know what an index is. A market index is normally a collection of stocks that are listed on a stock exchange. Canada’s most well-known index is the S&P/TSX, which consists of 231 of Canada’s largest companies by market capitalization. The Wall Street alternative is the S&P 500 index, which includes the top 500 listed companies in the US.
You’ll notice these indices are frequently cited in the media because investors use them to track the overall performance of a market. They rise and fall depending on a range of economic indicators and company news. For example, when an economy is healthy, its stock market indices tend to rise because investors feel more confident buying stocks. If trade tensions increase between countries, stock market indices usually fall as investors become nervous.
Index funds hold a selection of stocks that make up an index. For example, Vanguard’s VCN tracks a collection of 202 of Canada’s largest companies.
If a company leaves an index, the fund manager simply sells its shares and replaces it with new stocks. For this reason, index funds are considered a comparatively safe, albeit less exciting, alternative to directly buying shares in a company. Because these kinds of funds require minimal management, it’s known as “passive” investing.
What is an ETF?An ETF is a basket of securities that’s listed on a stock market, such as the TSX. In Canada, ETFs are typically “passive” investments that track an asset or index, but this isn’t always the case. You can read more about these funds in our informational ETF guide.
Most ETFs are similar to traditional index funds in that they are low-cost and track a major underlying index, though there are a few key differences:
- ETFs are listed. The main difference is that ETFs are traded like shares on the stock exchange while index funds are unlisted managed funds.
- They’re priced differently. The price that you pay for an ETF is its market value depending on its performance on the stock market. The price that you might buy or sell into an index fund is the net asset value of its underlying securities.
- Buying and selling. ETFs can be bought or sold at any time during a trading day, whereas managed funds are only priced at the end of the day.
- ETFs have lower minimum investment. Index funds typically require a higher minimum investment of more than $5,000. Many ETFs can be purchased for less than $100.
- Index funds don’t charge a transaction fee. There’s almost always a brokerage fee involved when buying or selling an ETF, but index funds tend to skip this cost. This means that a managed index fund can be a good option for investors looking to frequently add small amounts to their fund over time.
- ETFs have lower fees. On the other hand, taxation and management fees tend to be lower for ETFs than traditional index funds.
Simply put, index funds have been proven to outperform many other kinds of investments.
In 2007, one of the world’s most successful investors, Warren Buffet, made a $1 million bet that a bundle of active managed funds would be worse off than the S&P 500 over 10 years. He argued that if a fund simply mimicked a major index, it would deliver better returns than a fund actively managed by professionals. A decade later, Buffet won that bet.
The point is that although major indices fluctuate from year to year, they usually rise over a long period of time. For example, the TSX lost 35% of its value during the 2008 global financial crisis. But even if you had invested in the index fund just prior to that, you’d still be in a better financial position today than if you’d not invested at all.
- Index funds cost less. Passive funds require less legwork, so they typically charge lower fees than actively managed funds. In managed funds, high fees can easily eat into any returns gained by the broker.
- They can achieve higher returns. Indices have been proven to frequently beat the average returns achieved by fund managers over many years. Coupled with lower fees they make good investing sense.
- Ease of trade. Many ETFs listed on the TSX are index funds, which are easily accessible on trading platforms.
- It can diversify your portfolio. Investing in an index fund offers access to a range of companies from various sectors.
- They’re relatively safe. Index funds are considered a safer alternative to direct stock market investing because indices are generally less volatile than individual stocks.
Of course, no investment is ever 100% “safe” and you should always seek professional advice before making any investment decision. Here are some of the risks that investors need to be aware of:
- You could lose your money. Like any investment, you take the bad with the good. When an index does well, your investment delivers profitable returns, but when an index drops, so does your investment.
- It’s not a short-term plan. Passive funds perform best over many years. If you invest in an index fund but find you need the money 6 months later, there’s a good chance you’ll have less than you started with.
- Not all assets are safe. Although many index funds track relatively safe major indices, technically any pool of assets can be bundled into a fund. Some index funds track volatile global markets, such as the oil sector, while others bundle in riskier investment assets. Always do your homework.
- Not all ETFs are index funds. ETFs come in all shapes and sizes and not all are passively managed. Some are highly complex and risky.
|Vanguard S&P 500 EFT||S&P 500||ETF|
|iShares Core S&P/TSX Capped Composite Index ETF||S&P/TSX Capped Composite Index||ETF|
|iShares S&P/TSX 60 Index ETF||S&P/TSX 60 Index||ETF|
|BMO S&P TSX Capped Composite IDX ETF||S&P TSX Capped Composite Index||ETF|
Traditional index funds can be purchased directly through their associated fund providers, such as Vanguard Investments or BlackRock. ETFs can be purchased with any regular stockbroking account.
Whether you want to invest in an ETF or an unlisted index fund, these are the steps you need to follow:
1. Consider your strategy
Ask yourself what you want to achieve through this investment. Consider your time frame and how much risk you’re willing to take on. Will you need to withdraw the funds in a year’s time or can they sit for 10 years?
2. Assess your options
Compare funds online to find a product that matches your goals. Consider the risks, the fund’s performance, the brokerage fees and other transaction costs.
Key things to take into account when deciding on an index fund:
- Brokerage fees
- Transaction fees
- The fund’s performance over the last 3, 5 and 10 years
- Are the fund’s assets safe or does the fund contain some volatility?
- The minimum investment amount and how often you plan to transact with the fund
3. Sign up through a fund manager or online broker
Once you’ve found the right product, you’ll need to work out the best way to access it.
Index funds can be accessed through their fund providers such as BlackRock or Vanguard Investments.
- When applying directly to a fund manager, you’ll need to fill out an application form, provide proof of address, ID and tax identification number (or SIN). This will need to be posted or emailed back with a cheque or proof of transaction.
- Financial planners can also apply for an index fund on your behalf.
ETFs are accessible on most online trading platforms and can be purchased just like any other stock. You’ll need to sign up for an online share trading platform. To do this, you’ll need to:
- Provide personal details and proof of ID
- Transfer money into your trading account
- Log in to your account
- Search for the ETF you want and place a buy order
For more information about ETFs make sure to check out our extensive guide.
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