Tracking the market

Tracking the market

Are index funds a good choice for you?

Though it’s classified as a style of investment management, index investing could be described as a style of non-management. When applied to mutual funds, for example, index investing calls for the fund manager to hold the stocks that make up the selected market benchmark – or index – in the same proportions that they’re held by the benchmark.

Some fund managers track the performance of the selected market index by buying the stocks that make up the index in the same proportions that they’re contained in the index itself. In other types of funds, index options are used to achieve this replication. In either case, there’s no need for managers to analyze and select fund holdings and, for this reason, indexing is often referred to as a passive style of fund management.

Most of the index funds in Canada are based on major Canadian and U.S. equity markets; a few funds track various other foreign stock markets, either singly or in combination, while a smaller number mirror specific bond indexes and blends of stock and bond benchmarks.

Growing in numbers

The number ofndex funds has been growing as investors become increasingly aware of their advantages, not the least of which is that many index funds have managed to outperform their actively managed counterparts in the long term.

In addition to solid past performance, low cost is another reason why index funds are gaining popularity. Because indexing is a passive strategy, it doesn’t draw on the most labour-intensive aspects of fund management and is relatively cost-efficient. In particular, when stock analysis and security selection are left out of the process, the costs associated with a fund can be substantially lower.

These savings are passed on to index-fund holders: Management expense ratios (MERs) on a diversified Canadian equity mutual fund tend to be considerably higher than a comparable index fund, sometimes costing twice as much. (A fund’s MER represents its management fee plus administrative charges expressed as a percentage of total assets)

In contrast to actively traded fund portfolios, the buy-and-hold strategy employed by index funds means that holdings are adjusted only when and if changes are made in the underlying market index. This low portfolio turnover can make a big difference in terms of tax efficiency. A mutual fund’s buying and selling of stocks can generate capital gains – and remember that these gains are passed on to you, the investor, along with the tax liabilities. (Of course, this would be a consideration only for funds you hold outside your RRSP, RRIF or other registered plan since they’d be sheltered from tax within such plans.)

Given these features, there are good reasons for making an index fund a core holding of your fund portfolio. However, there are also potential drawbacks to consider.

Ups and Downs

The flip side to to passive management is that tracking an index also entails giving up the chance that you fund will outperform that index. What’s more, while it can be wonderful watching your index fund follow a soaring market benchmark, remember that your fund will also follow the market down. To the extent a fund manager adds value to a portfolio, you’re likely to miss active management most at uncertain times, such as when the market is falling.

Be aware also that, although the concept of indexing is often used to signify diversification, this isn’t always the case. For example, if a stock in the underlying index experiences an extraordinary run-up in price, your fund investment will mirror this heavy weighting. In such cases, even by doing nothing, you could end up with a large portion of your assets in one security.

It’s also important to recognize that not all indexes are the same and you should ensure that an index mutual fund’s target index is suitable for the goals you want to accomplish. For example, if you’re looking for the relative stability and moderate growth that comes from investing in large, established companies, it would be a mistake to invest in a fund that tracks small-cap index, in which the focus is smaller, growth-oriented companies with more volatility.