Guys, I’m so sorry. I thought I wrote about this already long, long ago. I definitely should have. Index funds make up the backbone of my personal investing philosophy, and I can’t believe I haven’t already written an article explaining what they are and how they work! Time to fix that.

Index Funds: A Special Type of Mutual Fund

Index funds are a specific type of mutual fund. If you don’t know what that is, I did write an article about that one a while back. In short though, a mutual fund is an investment that pools your month together with a bunch of other people’s money to give you the collective buying power to buy a bunch of different stocks or other investments. They get you exposure to a level of variety in your investments that few investors could afford individually.

You can find all sorts of mutual funds out there; there are funds that invest in specific sectors (like energy, for example), funds that invest only in dividend-paying stock, and funds that focus only on a specific size of company.

Index funds are unique, in that they are designed to track the movements of the specific index they were designed for. So an index fund that tracks the Toronto Stock Exchange (TSX) would own all of the largest stocks that make up that index, so that the fund performs very similarly to the movements of the index itself.

Index funds exist for all kinds of investments, not just stocks. There are index funds for bonds, index funds for real estate, and many others. You can also find an index fund that tracks just about every major stock market in the world.

Benefits of Index Funds

Man, where do I even start?

Reduce Risk through Diversification

By investing in an entire index, you reduce the chances of losing all your money in a bad stock pick to basically zero. In order for an index fund to lose its total value, all of the major companies in the country the index is based in would essentially need to declare bankruptcy at the same time. Frankly, if that happens, we have way, way bigger problems than our investments.

Lower Management Fees

Second, index funds are what’s known as passively managed funds; that is, there is no fund manager who is constantly looking at the market deciding what to sell and what to buy. Because the index fund tracks an entire market, the only time it will buy and sell is if the companies that make up the index itself fluctuate significantly.

Blah blah blah, gibberish, means nothing to me. Mmmk. Fair enough, until you realize that someone pays for those fund managers to do all that research and buying and selling, and that someone is you, my friend. The cost to pay a fund manager on a regular mutual fund can be as high as 3% annually, whereas on an index mutual fund it’s usually well below 1%.

What kind of difference does 2% a year make on your investments? Well, if you had $100,000 invested over 30 years, you’d have over a million dollars at 8% a year, but only $575,000 at 6% a year. That’s a pretty big difference to the size of your nest egg, don’t you think?

You’ll Outperform Most Actively-Managed Funds

By definition, index funds give you the average market return. That means that, in any given year, some funds will do better, and some will do worse. Over the long run however, the irony is that you’ll actually outperform most actively-managed mutual funds. That’s because actively-managed funds need to beat the market by at least the amount of their annual fees in order to compete with your index fund… and that just doesn’t happen that often over periods of many years.

Will you ever get lucky and get stinking rich off your investments? Nope. You can kiss the chances of picking that lucky “unicorn” that makes your investment go up by 100x goodbye. But you will earn a healthy annual return on your money and set yourself up for a nice retirement, and that to me is worth way more than the distant chance of picking a big winner.

You’ll Pay Less Tax on Your Gains

Ok, this section is going to get a little technical, so feel free to skip it if you feel like it might put you into a coma.

If you’re investing in a taxable account – that is, you’re not putting your money in a registered account like an RRSP or TFSA – then you’ll pay taxes on the gains you make with your investments when you sell them off. The amount of those taxes depends heavily on the type of gains and the frequency with which you buy and sell.

Because index funds are passively managed – again, meaning they only buy and sell underlying investments when they have to – the amount of capital gains tax you’ll pay each year is relatively low. With actively-managed funds, where the fund manager is buying and selling the underlying stocks multiple times a year, you might pay far more tax, which reduces your overall return even lower than the management fee alone.

This doesn’t matter if you’re in a tax-free or tax-deferred investment, but it can make a big difference if that’s not the case. Just another feather in the index fund’s cap.

One Caveat on Index Funds

As much as index funds have going for them, there’s one thing you need to keep in mind: because the fees on them are so low, your financial advisor will make little to no money for investing your savings into them. For this reason, many commission-based advisors will try and talk you out of index investing. This also means that if you want to invest in index funds, you’ll generally need to do it yourself.

As we saw earlier, the benefits of doing so are huge. That said, I also know from experience that most people would rather have their arm amputated than manage their own investments. If that describes you, then you’ll still get better returns in a good mutual fund than you would get if you put your money into a savings account or GIC. Just know that, over the long term, you’re potentially leavings hundreds of thousands of dollars on the table as the price for that service.

Wrapping it Up

Index investing is my preferred method for saving for retirement. It’s easy, comes with minimal fees that eat away at your money, and over the long term has offered strong historical returns. If you’re interested to manage your own investments and want a pain-free strategy, this is the way to go. You can manage a portfolio of index funds – and by portfolio, I literally mean two or three – by spending only a few minutes a year looking at your investments. There’s even a whole website, called the Canadian Couch Potato, dedicated to index investing. It’s run by a guy named Dan Bortolotti, and it’s fantastic.

With the right strategy and mix of index funds, it’s even possible to beat the market by a small margin over the long-term, by periodically rebalancing your portfolio. That’s a subject for another post though 🙂