The mechanics of index funds

Recently, a reader asked for more information about index funds. “I believe ‘couch potato’ describes the holder of index funds,” he wrote. “From the information I have, there’s no MER charge with index funds. That alone can save three to five per cent. Can we have more information?”

Index funds are certainly worth considering. But the note contains some erroneous assumptions that suggest many people don’t have a clear understanding of index funds.

Basically, these funds are simple. Each is designed to track the performance of a benchmark index. For Canadian equity index funds, the S&P/TSX Composite Index is most commonly used. Funds that focus on U.S. stocks usually track the S&P 500, which comprises the largest 500 companies in the States, although a few track the Dow Jones Industrial Average.

There are also a number of funds that track bond indexes. The one most commonly used is the Scotia Capital Markets Universe Bond Index, but there are also funds that focus on short-term bond indexes and government bond indexes.

There are two types of index funds. Contrary to our reader’s assumption, many index funds are actually mutual funds. Several of thbanks offer a variety of index mutual funds, with CIBC and TD providing the largest selection.

Classic exchange-traded funds (ETFs), which trade on stock exchanges, are also based on an index. The best known in Canada are the 12 iUnits from Barclays Global Investors that are listed on the Toronto Stock Exchange. They cover a variety of indexes from the S&P/TSX 60 (our equivalent of the Dow) to specialized indexes that track gold stocks, energy shares, etc. There are two bond iUnits, one of which emulates the Universe Bond Index. It trades under the symbol XBB.

Exchange-traded funds are big business on U.S. exchanges. Morgan Stanley offers almost 100 of them under the iShares brand, covering everything from the NYSE Composite Index to individual country indexes.

You must purchase ETFs through a broker, and a commission is payable.

Varying costs
Costs will vary. Our reader believes that index funds have no MER (management expense ratio). This is not the case. They all have some embedded cost. However, the MERs of index funds are usually a lot less than that of actively managed funds, in which a manager selects the securities.

There is significant variation in the MERs from one type of index fund to another, and you need to be mindful of that in making a selection. If you decide to go the iUnits route, your MER will be anywhere between 0.17 per cent and 0.55 per cent. The best values are the iUnits S&P/TSX 60 Index Fund (TSX: XIU) at 0.17 per cent and the iUnits Government of Canada Five-Year Bond Fund (TSX: XVG) at 0.25 per cent.

Although iUnits have lower MERs, the fact you have to pay a sales commission to acquire them adds to the total cost. You may prefer a no-load index mutual fund instead. The MER is a little higher, but there’s no commission to pay.

Among mutual funds, the best values are the “e” units offered by TD Asset Management. These funds can only be purchased on the Internet through a special account, but if you’re comfortable with that, they represent a great deal. For example, the regular units of the TD Dow Jones Average Fund carry MER of 0.89 per cent. But the e-units of the same fund charge only 0.32 per cent. The difference goes straight to the bottom line in terms of your return.

Finally, be aware of the risk involved. Index funds rise and fall in line with what happens to their benchmark. That means there is no hiding place when times are rough. During the bear market, the TD Canadian Index Fund lost almost 13 per cent in both 2001 and 2002. So if you’re going to be a “couch potato,” be prepared for the ups and downs.

The safest index funds are those based on short-term bond indexes, such as the CIBC Canadian Short-Term Bond Index Fund. The most risky are those that track a sector index. The Information Technology iUnits (TSX: XIT) lost 59 per cent in 2002 and then proceeded to gain most of it back the following year. That’s heart-stopping stuff. Don’t go there unless you can handle it.