Topic: ETFs

Tips for Investing in Index Funds Through the Use of ETFs

Investing in index funds can be easier and more secure if you use exchange traded funds (ETFs) because these modern investment products come with a tax-friendly structure and provide lower management fees than many competing options such as traditional mutual funds

Exchange traded funds (ETFs) are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

Exchange traded funds trade on stock exchanges, just like stocks. Investors can buy them on margin or sell them short. Using ETFs for investing in index funds has gained popularity among investors, mainly because many ETFs offer very low management fees.


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Three portfolio advantages of investing in index funds

  • Index funds can help you avoid the risk of choosing a mutual fund with a management style that virtually guarantees below-average long-term performance.
  • Index funds can give investors with limited funds a low-cost way to get wide stock-market exposure.
  • Index funds typically have low annual fees.

Specific reasons why investors like ETFs for investing in index funds

The MERs (Management Expense Ratios) are generally much lower on ETFs than on conventional mutual funds—including mutual funds that hold indexes. That’s because most ETFs take a much simpler approach to investing. Instead of actively managing clients’ investments, ETF providers invest so as to mirror the holdings and performance of a particular stock-market index.

ETFs practice this “passive” fund management, in contrast to the “active” management that conventional mutual funds—or even actively managed ETFs—provide at much higher costs. Traditional ETFs stick with this passive management—they follow the lead of the sponsor of the index (for example, Standard & Poor’s). Sponsors of stock indexes do from time to time change the stocks that make up the index, but generally only when the market weighting of stocks changes. They don’t attempt to pick and choose which stocks they think have the best prospects.

This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

We prefer ETF index funds over buying index mutual funds for three main reasons

  • Index ETFs offer you a lower-cost alternative to index mutual funds. With fees as low as 0.10% a year for index ETFs versus index mutual funds that can charge you 1.20% or higher, ETFs can save you a lot of money and boost your returns if you are investing over time.
  • Index ETFs trade on stock exchanges, just like stocks. That’s different from index 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.

If you want to own mutual funds, focus on index mutual funds

One big advantage of index mutual 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. The managers of these funds try to outperform the market by betting on relatively short-term trends. This can work in any one year. But over a decade, the top funds are generally those run by conservative managers who focus on long-term growth in the economy.

Another advantage of index mutual funds is that they can give investors with limited funds a lower-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 mutual funds, you can buy them through almost any mutual fund company. This includes the big-five banks.

Make sure your portfolio selections include these considerations if you’re investing in index funds like ETFs

  • Know the liquidity of ETFs you invest in.
  • Know how broad the fund is, so you can determine its volatility. The broader the ETF, the less volatility it may have. A sector-based ETF such as one that tracks resource stocks may be more volatile.
  • Know the economic stability of countries when investing in international ETFs. It’s also good to mention that foreign leaders may not be your ally when it comes to passing legislation that can affect your investments
  • Determine if the ETFs you buy will include capital gains distributions.
  • Consider buying ETFs in a lump sum rather than periodic small amounts to cut down on brokerage fees.

What are the reasons you choose to invest in ETFs over mutual funds?

Do you combine ETFs and index mutual funds in your investment portfolio? What advantages does each have over the other?

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