Topic: ETFs

How to pick the best Canadian index funds

Canadian Index Funds

Canadian index funds are among the better financial innovations to come along in the past few decades

Canadian index funds are specialized mutual funds that aim to equal the performance of a Canadian market index, such as the S&P/TSX 60.

Canadian index funds do show better long-run performance than more than half of actively managed mutual funds with long-term track records. That’s partly because index-fund fees run as low as 0.10% of assets per year, compared to 2.5% or more on many mutual funds.


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Advantages of Canadian index funds

One big advantage of index funds is that they can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance.

For example, in our view, mutual funds that pursue a trading or sector-rotation approach belong in this sub-par category. These funds’ managers try to outperform the market by betting on relatively short-term trends. This can work in any one year, say. But in any one decade, the top funds are generally run by conservative managers who focus on long-term growth in the economy.

Another advantage of index funds is that they can give investors with limited funds a low-cost way to get some stock-market exposure. They can also be a good starting point for a registered education savings plan (RESP), or an in-trust account. Many investors also consider them when they invest funds in their tax-free savings accounts (TFSAs).

If you want to invest in Canadian index funds, we routinely update subscribers to our Canadian Wealth Advisor newsletter on the best deals available. One example is the iShares S&P/TSX 60 Index ETF (Toronto symbol XIU). The fund’s units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Most of the stocks in the index are high-quality companies. You pay a commission to buy this fund (through a broker), but the fund’s yearly expenses are just 0.17% of assets.

Bonus Report: Three tips for investing in Canadian mutual funds

Avoid mutual fund managers who trade heavily

If you do decide to invest in mutual funds instead of Canadian index funds, then be aware that some of the most dangerous mutual funds are those run by mutual fund managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their index fund’s performance comes to disaster each year, until disaster finally strikes.

If you add up a heavy trader’s losses at the end of a given year, they may amount to a high percentage of their fund’s assets (25%, for example). That may seem perfectly acceptable to the mutual fund manager, so long as the profits on their winning trades are significantly higher than that (for example, 75% of assets).

If the mutual fund manager guesses wrong a few times, however, it’s all too easy to reverse those figures: that is, have losses totalling 75% of assets and profits totalling 25%, so that the fund loses 50% of its capital. If the manager delves into low-quality or highly volatile choices, as heavy traders are apt to do, then the fund’s performance can drop.

Beware of buying vaguely described Canadian mutual funds

Canadian index funds generally follow a well-defined index. But be careful investing in Canadian mutual funds that show wide disparities between the fund’s portfolio and the investments that the sales literature describes.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect.

Avoid buying Canadian mutual funds with anonymous managers
This includes buying Canadian mutual funds run by committees. The trouble here is that the brains of the index fund may leave, and investors would never know it until they saw the drop in their index fund’s performance

Why we prefer ETF index funds over buying index mutual funds

  1. ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in a mutual fund with a similar focus. With fees as low as 0.10% a year for ETFs vs. mutual funds that can charge you 2% to 3% or higher on their fund. ETFs can save you a lot of money and boost your return if you are investing over time.
  2. ETFs trade on stock exchanges, just like stocks. That’s different from mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.
  3. Low turnover. Shares are only added or removed when the underlying index changes. As a result of this low turnover, you won’t incur the regular capital gains taxes generated by the yearly distributions most conventional mutual funds pay out to unitholders.

If you decide to invest in individual stocks, as well as Canadian index funds, you should take care to spread your money out across the five main economic sectors: Finance, Utilities, Consumer, Resources & Commodities, and Manufacturing & Industry.

By diversifying across most if not all of the five sectors, you avoid overloading yourself with stocks that are about to slump simply because of industry conditions or investor fashion.

You also increase your chances of stumbling upon a market superstar—a stock that does two to three or more times better than the market average.

Have you invested in Canadian index funds? Have they been profitable for you?  Share your experience with us in the comments below.

Note: This article was originally published in May 2015 and was last updated on Nov, 2016.

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