The basics of these investment funds
Here’s an overview of some key basic features of index funds vs mutual funds.
Index funds
- Track the performance of a specific market index, such as the S&P/TSX Composite Index or the S&P 500
- Typically have lower management expense ratios (MERs) compared to actively managed funds like mutual funds, often ranging from 0.05% to 0.50% in Canada
- Give investors a broad exposure to a specific market segment and provide instant diversification
- Ideal for beginner investors who prefer a hand’s off approach or for those who want to save money on fees
Mutual funds
- Investment product that pools money from many investors to purchase a diversified portfolio of securities, such as stocks and bonds
- Have high MER fees because they are actively managed by a portfolio manager. Fees can average 2.28%
- May appeal to investors willing to pay higher fees for the potential to outperform the market
What is an index fund?
An index fund tracks the performance of a specific market index, such as the S&P/TSX Composite Index in Canada. An index fund's goal is to mimic the performance and returns of a specific index as closely as possible by holding a representative number of equities that make up the relevant index. This is called a passive investment strategy because the fund manager seeks to replicate the index's composition rather than actively selecting individual stocks or attempting to outperform the market.
For example, if an index fund tracks the S&P/TSX Composite Index, which is made up of approximately 250 publicly traded large Canadian companies, the fund will hold a proportional investment in all or a majority of those companies.
What is a mutual fund?
A mutual fund is an investment product where many investors pool their money to purchase a diversified range of securities, such as stocks, bonds or other assets. The funds do not track a specific index. Additionally, unlike index funds, which are passively managed, mutual funds are actively managed by a portfolio manager, supported by a team of researchers and financial consultants. Because these funds are actively managed, they come with higher fees. An index fund hopes to mirror the performance of leading companies in the stock market, whereas mutual funds hope to figure out an ideal mix of stocks to outperform the market.
| Index Funds | Mutual Funds | |
|---|---|---|
| Investment objective | To meet the returns of the benchmark index (e.g. S&P 500, TSX Composite) before fees | To outperform the benchmark index after fees |
| Types of investments | Stocks, bonds (government, corporate), other cash instruments | Stocks, bonds (government, corporate), other cash instruments |
| Management approach | Passive. Asset mix is built to match the exact make-up of the benchmark index | Active. A fund manager determines the securities (stocks/bonds) to buy, hold, and sell |
| Typical management expense ratio (MER) | 0.66% | 2.28% |
| Annual fee on $100,000 | $660 | $2,280 |
| Growth of $100,000 over 30 years (7% annual rate of return) after fees | $630,484 | $398,923 |
Differences between mutual funds and index funds
Passive vs. active management
One of the main differences between index funds vs mutual funds is the way they are managed. Index funds are passively managed, meaning the fund manager’s primary goal is to mirror the performance of a specific market index by holding the same securities in the same proportions as the index. The manager doesn’t really make any investing decisions or need to research the market to predict which stocks will soar. The manager’s primary goal is to ensure the index funds form a representative sample of the desired index. The manager only changes the composition of the index fund if the underlying index itself changes, such as when a company may start performing poorly and be removed from the index.
On the other hand, mutual funds are often actively managed, which means the fund manager is continually making decisions about which securities to buy and sell. This active management is driven by the goal of outperforming the market or a specific benchmark, keeping the manager and the investors engaged in the fund's performance. This is why fees for these type of investments are higher.
Investment objectives
Investors who embrace passive investing through index funds are following the belief (backed by empirical and academic research) that building a low-cost, globally diversified portfolio that simply tracks the market, leads to the best investor outcomes over the long term.
The theory behind avoiding active management is that high fees and bad individual behaviour lead to poor performance. Instead, buy index funds, and investors will achieve market returns minus a small fee.
Proponents of active management through mutual funds don’t believe in settling for “average” returns. They strive to outperform the index through superior stock picking and market timing skills. It sounds great in theory, but in reality, the vast majority of actively managed mutual funds fail to beat their benchmark index after fees.
The late Jack Bogle, Vanguard founder and father of index investing said:
“What happens in the fund business is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact."
Costs
It makes good sense that a mutual fund that has to pay managers, researchers, marketers and salespeople will cost more than a bare-bones index fund that represents an index. These costs are passed down to investors through the management expense ratio (MER).
An actively managed mutual fund may charge a 2.25% MER. Here’s how those costs break down:
- Administration charges (overhead): 0.25%
- Fund manager fees (including profit): 1.00%
- Trailing commission (split between advisor and firm): 1.00%
- Total: 2.25%
Investors pay more to own actively managed mutual funds to, theoretically, outperform the market. Yet, all evidence shows that high costs guarantee an active mutual fund will underperform its benchmark.
Many investors misunderstand how much a 2% fee is. It’s not 2% of 100%. It’s 2% in the same context as earning a 6% return on your investment. Take away 2% in fees and you’re left with just 4% in investment returns. Don’t make the mistake of thinking a couple of percentage points don’t matter – in the long run, they’re huge.
Index funds charge fees, too, but much less than mutual funds. That’s because index funds typically do nothing more than track broad market benchmarks like the S&P 500. In our example in the chart above, we made two hypothetical investments – one in an index fund and another in an actively managed mutual fund. Both funds earned 7% per year (before fees) for 30 years. The index fund cost 1.62% less than the actively managed fund and its “investor” ended up more than $231,000 richer.
If you’re not comfortable with DIY investing but want to cut costs, take a look at the best robo-advisors in Canada. You’ll typically pay less than 1% in fees, but get the benefit of a customised portfolio that suits your goals and risk tolerance. You also won’t have to worry about rebalancing that portfolio once a year — a robo-advisor like Wealthsimple will do that for you.
Best ways to invest in index funds
These days, passive investors who want to invest in index funds are turning to online brokerages — a low-cost trading platform that lets you buy and sell stocks online. From your computer, tablet, or mobile phone, you can easily design your own asset allocation and portfolio made up of index funds. There are some great online brokerages in Canada, but our top choices are Wealthsimple Trade and Questrade. Both platforms allow investors to purchase ETFs for free, and read our Wealthsimple Trade vs. Questrade breakdown for an in-depth comparison.
Still learning how to invest? Consider using a robo-advisor — an automated investment service that can build you a personalized portfolio in mere minutes using algorithms. An excellent robo-advisor, like Wealthsimple, can recommend a portfolio comprised of low-cost ETFs and/or index funds. It’s a smart strategy to cut costs and maximize your return on investment.
Do index funds outperform mutual funds?
The rise of actively managed mutual funds began in the 1990s when interest rates started to fall, and Canadian investors sought higher returns. Mutual funds enabled all types of investors, large and small, to access markets at a low cost, with no commissions to buy and sell funds. Active managers provide professional portfolio management, diversification, and opportunities for investors to access foreign and domestic markets.
Active management is often touted as a way for investors to outperform the market thanks to superior investment strategy and insights from the fund manager and research team. Another perceived benefit is the ability of active managers to “avoid” market corrections by making real-time decisions to buy or sell securities and help protect investors’ downside.
In reality, most active managers fail to outperform their benchmark index over the long term. Their ability to avoid market downturns is also overstated. According to the SPIVA Scorecard, more than 88% of Canadian Equity active managers underperformed the S&P/TSX Composite over the 10-year period ending in June 2019.
Simply put: it’s hard to pick winning stocks. It’s hard to time the market. And it’s impossible to identify the best active managers ahead of time – you can only look backwards to see how each manager performed.
Passive investing has only become popular in the last 10 years, and Canadian investors still need to catch up with other countries in the global shift from active to passive strategies. Passive investing makes up just 10% of the market in Canada, whereas nearly half the funds invested in the United States are passively held.
Index funds typically charge a fraction of the cost of their actively managed counterparts. That’s because index funds use a rules-based methodology to track their benchmark index passively. They don’t rely on an active manager to judge which stocks and bonds to hold and when to buy and sell them. With no fund manager or researchers to pay, those savings get passed down to the investor through lower fees.
Best ways to invest in index funds
These days, passive investors who want to invest in index funds are turning to online brokerages — a low-cost trading platform that lets you buy and sell stocks online. From your computer, tablet, or mobile phone, you can easily design your own asset allocation and portfolio made up of index funds. There are some great online brokerages in Canada, but our top choices are Wealthsimple Trade and Questrade. Both platforms allow investors to purchase ETFs for free, and read our Wealthsimple Trade vs. Questrade breakdown for an in-depth comparison.
Still learning how to invest? Or consider using a robo-advisor — an automated investment service that can build you a personalised portfolio in mere minutes using algorithms. An excellent robo-advisor like Wealthsimple can recommend a portfolio composed of low-cost ETFs and/or index funds. It’s a smart strategy to cut costs and maximise your return on investment.
Last word: Should you buy index or mutual funds?
Investors should aim to keep their investment costs low and avoid making active judgements on buying, selling and timing the market. For that reason, index funds trump mutual funds.
New to index funds? Our beginner’s guide to investing in index funds will give you all the details about how to get started. If you’re comfortable with DIY investing, index funds are especially easy to buy and sell through an online brokerage. Check out our ultimate guide to Canada’s discount brokerages to find one that best suits your needs.
Don’t want to pick your own index funds? Consider a robo-advisor like Wealthsimple, which will build you a custom portfolio of index ETFs and automatically monitor and rebalance your portfolio.
With files from Sandra MacGregor
If you liked this article, you may also enjoy:
