Squawkfox

I tend to get really excited when I talk to friends about index funds and exchange traded funds (ETFs). My friends usually greet me with perplexed looks and rolling eyeballs when I start squawking about the importance of avoiding loads, axing MERs, and not blindly trusting “financial advisors” who sell you funds based on targets, trailer fees, and commissions. All these funny fees I just mentioned are a thing of beauty for mutual fund companies. These companies love-love-love fees for the same reasons you should hate-hate-hate fees. Fees cost you big bucks. Fees earn mutual fund companies HUGE bucks. So what’s a little investor with a little cash to do? The answer is simple, consider index funds or ETFs!

What the Heck are Index Funds?

Index funds are a type of mutual fund that tends to be managed by a computer, and are therefore a form of passive management. There’s no manager actively watching over these funds and getting paid for trying to be smarter than the market. Index fund assets are invested to replicate an existing market index such as the TSX, S&P 500, or MSCI EAFE. Over time, lets say 10ish years, index funds typically outperform the majority of actively managed mutual funds. How the heck is this possible? How can a computer, with very little education and financial know-how beat all these highly-paid money managers? The answer is simply cost. Most active fund managers cannot overcome the handicap of high operating expenses that pull down a fund’s rate of return. For example, an average Canadian stock mutual fund has a management expense ratio of 2.50 percent per year. A low cost Canadian stock index fund costs about 0.30 percent a year. The difference is a whopping 2.20 percent advantage for the index fund. Wouldn’t you rather keep that extra growth in your portfolio? I know I sure would.

Index Fund Advantages:

• Cost: The lack of active management (stock picking, buying, and selling) in an index fund gives it the advantage of lower fees and lower taxes. Also, you don’t pay broker fees to buy and sell index funds, which is a huge advantage for those investors with smaller portfolios and those who invest on a regular basis. Paying broker fees can very quickly eat up you portfolio!
• Passive Tracking: Does it seem strange that all mutual fund returns are compared with an index as a reference point? The sad truth is not many mutual funds beat the index. So why not just track the index and pay a whole lot less?
• Cannot Underperform the Index: Since index funds track the index, you really cannot underperform the index like so many actively managed mutual funds.

Index Fund Disadvantages:

• Company Dominance: The biggest downside of investing in index funds is if/when just a few large companies dominate the index. Canadians saw this happen in 2000 when Nortel Networks Corp. expanded rapidly and accounted for about 30 percent of the S&P/TSX index. Those investors in index funds at this time lacked portfolio diversification with so much of their investment tied to the outcome of one single company. When the tech market melted in 2001, so did the portfolios of many Canadian equity S&P/TSX investors.
• Tracking Errors: Some people argue it is impossible to precisely mirror an index with 100 percent accuracy. Computers react to market fluctuation, sampling and mirroring techniques are not perfect. The difference between the index performance and the fund performance is known as the “tracking error”.

Where Do I Buy Index Funds?

These days index funds are getting popular, and rightly so. Big players like ING Direct, TD Canada Trust, and the Canadian Imperial Bank of Commerce (CIBC) all offer different flavors of index funds. One thing to watch out for though are packaged portfolios of funds. A packaged portfolio of funds is a number of index stocks and index bonds diversified into a managed portfolio. Basically, you pay a lot more in fees for someone to put together an asset allocation of stocks and bonds for you. You’re much better off just buying each individual index fund yourself and creating your own asset allocation. I talk about doing this my posting comparing ING Streetwise Funds with TD e-Series Funds. To keep things simple, the index fund offering with the lowest fees are the TD e-Series Funds (Disclosure: I own TD e-Series Funds). To buy index funds, just open a mutual fund or discount brokerage account with the issuing institution.

What the Heck are Exchange Traded Funds?

Exchange Traded Funds (ETFs) are baskets of securities which track the performance of a stock, bond, or commodity index. Unlike index mutual funds, ETFs are similar to stocks. ETFs trade on the stock market, have ticker symbols, and are only available though brokers and discount brokers.

Exchange Traded Fund Advantages:

• Flexibility: Exchange Traded Funds combine the benefits of index diversification, low operating costs, and have trading flexibility of individual stocks.
• Cost: ETFs also tend to have lower fees than index mutual funds. Lower fees are a HUGE plus if you have a larger portfolio to invest.

Exchange Traded Fund Disadvantages:

• Brokerage Fees: The biggest disadvantage to investing in ETFs are broker fees. To buy and sell an ETF you could pay as much as $30. This cost can add up if you buy and sell frequently, or have a smaller portfolio to invest.

Where Do I Buy Exchange Traded Funds?

The biggest ETF player in Canada is Barclays iShares. The biggest player in the US is Vanguard. ETFs can be purchased though any discount brokerage account, including: TD Waterhouse, BMO InvestorLine, CIBC Investor’s Edge, Royal Bank Action Direct, Interactive Brokers, TradeFreedom, Questrade, and many more.

Index Funds Vs. ETFs: How Do I Choose?

Choosing between index funds and ETFs is really a matter how often you invest and how much you invest. Simply, if you’re like me and invest frequently (monthly even), then you should consider index funds to prevent paying considerable brokerage fees every time you buy. Index funds cost a little more to own due to higher MERs, but the broker fees can outweigh the lower MER advantage of ETFs. If you invest once-a-year, than consider investing in ETFs.

Final Thoughts

I wish my friends would actually listen to me when I swoon over index funds and ETFs. I suppose they close their ears cause they’re not interested in investing or perhaps just don’t want to face what they themselves are invested in. But since you have read to the end of this lengthy post, I do sincerely hope your mind is open to lowering your investing fees by considering index funds or ETFs for either your retirement (RRSP or 401K) or your non-registered portfolio. Happy investing!

fox