An index fund is a mutual fund that seeks to replicate the movements of an index of a specific financial market such as the S&P/TSX Composite Index, the S&P 500 or the Canada Universe Bond Index[note 1] This is accomplished by:
- Holding all of the stocks, bonds or other securities in the index, in the same proportions as the index, or
- Holding an optimized subset of the securities in the index, maintaining a very high correlation between the index itself and the subset.
Since the composition of an index fund is a known quantity, they generally have lower management expense ratios (MERs) than actively managed mutual funds. Another alternative is an exchange-traded fund (ETF), which may have lower costs but also has other key differences.
Asset class style consistency
Once an investor has crafted an investment policy statement and decided upon an asset allocation, the investor then implements the plan by selecting appropriate funds for the planned allocation. Index funds make suitable building blocks for asset allocation purposes because they can be trusted to remain reliably close to their declared style parameters.
The tendency for funds to shift their center of style gravity is termed "style drift", the divergence of a mutual fund from its stated investment style or objective. For example, an active large cap fund manager may invest in mid cap and small cap stocks, or add international stocks to the portfolio, or have the valuation style of the portfolio drift from value to growth. Such style drift takes the asset allocation control of the portfolio away from the investor and places it into the unpredictable hands of the fund manager. Another common example of style drift occurs when an active small cap fund grows exceptionally large. The fund usually must buy larger stocks, and will commonly see its center of style gravitate towards a mid cap style.
Comparison of index mutual funds and ETFs
Index mutual funds and index ETFs have some key differences that an investor should be aware of when making a choice. Some of these differences are covered in the following table:
|Index mutual fund||ETF|
|How to buy||Purchased directly from mutual fund company, or in brokerage account||Requires a brokerage account|
|Number & diversity||Relatively low number of funds available in Canada, but cover most of the main asset classes(a)||Very large number of ETFs available on TSX & US exchanges, covering almost all possible wishes|
|One-time costs||Most have no purchase or sale costs(b)||Has purchase(c) and sales fees (commissions); bid-ask spreads; buying US-listed ETFs may lead to currency conversion costs|
|Ongoing costs||MER usually >0.5%||MER often <0.5%, and as low as <0.1%|
|Dollars or units?||Buying and selling done in dollar amounts||Transactions involve whole ETF shares|
|Trade execution||End-of-day pricing of trades, exactly at the net asset value (NAV)||Immediate pricing of trades during market fours, at market prices (which may differ slightly from the NAV)|
|Distributions||Typically automatically reinvested||Typically paid in cash (can be automatically reinvested if the distribution is worth more than one share of the ETF)|
Because of these differences, index mutual funds are more suitable for small, frequent purchases (for example in systematic investment plans). Index ETFs are frequently cheaper for one-time major purchases.
If the investor has a brokerage account, then index funds and ETFs can both be used simultaneously. For example, the investor may want to add small amounts every month into his account, for which the index funds would be used (to avoid commissions, and the inconvenience of having to trade during the market hours). When the amount accumulated in each index fund warrants it (perhaps every couple of years), the index funds would be sold and the money reinvested into ETFs, with a single trading commission per fund. The process would then be repeated, with new contributions going to index funds. Note that if the investor wants to use the TD e-funds, such a strategy is only possible with a TD brokerage account.
How to choose index mutual funds
- Choose your detailed asset allocation before you look at specific investment vehicles.
- If buying index funds in a mutual funds account, make sure that the chosen provider offers all the funds you need. Some mutual fund companies only have a few index funds, others have a more comprehensive coverage of asset classes.
- In a brokerage account, funds from different providers can be mixed if desired.
- Avoid loads: numerous no-load funds are available.
- Look at the underlying index. Is it the most common one in this category? If not, does the index used by the fund under investigation correlate strongly, and have the same annualized returns, as the most common index?
- All else being equal, the lower the MER, the better, but also check the tracking error.
- Does the fund use currency hedging? This may or may not be a desirable feature.
Financial Wisdom Forum member Bylo Selhi has a list of no-load low-cost index mutual funds that is slightly outdated but provides an excellent starting point for investigation. A list of recommended index funds and ETFs is maintained by Canadian Couch Potato. You can also use the globefund filter, selecting "Load Type: No Load"; "Management Expense Ratio: <= 1.00%"; "Fund Type: Open-Ended"; "Index Funds: Yes". Most of the list consists of ETFs, but the index mutual funds are in there too; click on "key facts" to obtain the MER.
Impact of dividends on NAV (net asset value)
What happens to the dividends paid to the mutual fund by companies whose shares the index fund holds? Those dividends form part of the income of the index fund, and increase the fund's net asset value (NAV). They are usually aggregated, the fund is paid its MER, and the remainder is then paid out to holders of the index fund in the form of dividends.
Impact of distributions on NAV
What happens to the distributions paid out by the index fund to its unit holders? The NAV of the fund decreases by the amount of distributions paid out. Some unit-holders choose to DRIP, i.e. use the distributions to buy more units. The extra number of units just cancels out the drop in NAV, and the unit holder is left as before, except for some accounting.
- FTSE TMX Global Debt Capital Markets (formerly PC-Bond / DEX) is the predominant provider of fixed income indices in Canada, best known for the Universe Bond Index.
- Wikipedia, Index fund, viewed Feb. 21, 2009.
- FTSE TMX Canada Indices, viewed January 13, 2015.
- "Bylo Selhi", Low-MER, No-Load Index Funds Available in Canada, viewed Feb. 21, 2009.
- Style Drift Definition | Investopedia, viewed January 13, 2015.