What is index investing?

Index investing is a passive investment strategy that aims to generate returns that are similar to that of a market index, such as the S&P/TSX Composite Index, Dow Jones Industrial Average (DJIA) or Bloomberg Aggregate Bond Index.  

Unlike an active investing strategy, which aims to outperform the market, index investing tries to replicate the performance of a market index.

How does index investing work?

To use an index investing strategy, an investor would need to buy all of the securities held in an index, at the weightings in which they are held. But because an index can include hundreds of securities, this can be an expensive and time-consuming prospect for most investors. While the DJIA only holds 30 securities, imagine trying to replicate the constituent holdings of the S&P 500 Index, which holds 500 stocks, or the Russell 3000 Index, which holds 3000. 

The cost and effort to own and manage that many securities are usually more than the average investor is interested in. As such, index investing is usually accomplished through the purchase of an index mutual fund or exchange-traded fund (ETF) that closely tracks an underlying index.

What is an index?

When discussing stock or bond market performance, analysts and market commentators are usually citing the performance of an index, which measures the performance of a group or basket of stocks or bonds that are intended to represent the health of the market or a specific segment of it (industry, sector, market capitalization).

Indices can be used as a benchmark to help investors and analysts compare the performance of an individual stock or bond against its industry, peer group or the wider market. Some of the more widely known indices include the DJIA, which measures the performance of 30 major companies listed on U.S. stock exchanges, and the S&P 500 Index, which measures the performance of the 500 largest public companies in the U.S. Other prominent indices include:

• S&P/TSX Composite Index – measures the performance of Canadian stocks, comprising approximately 250 companies.
• MSCI EAFE Index – measures the performance of 21 indices in Europe, Australasia and the Far East.
• Bloomberg U.S. Aggregate Bond Index – measures intermediate-term investment-grade bonds traded in the U.S.
• Nasdaq Composite Index – measures the performance of over 3,000 companies listed on the Nasdaq exchange.

What is an index fund?

An index mutual fund or ETF is a collection of stocks or bonds that attempts to replicate the performance of an index. An index fund will be made up of the same investments that make up the market index it replicates, and aims to earn the same performance returns of the index.  

Do index funds outperform actively managed funds?

The SPIVA Canada Scorecard points out that actively managed mutual funds frequently do not outperform their indices, particularly over the long term. Taking Canadian equity funds as an example, over half (51.9%) of actively managed Canadian equity funds underperformed the index over a one-year period, and 84.9% underperformed the index over a 10-year period.

What are the advantages of index investing?

Diversification

Index investing provides greater diversification than actively managed strategies. Indices attempt to measure the performance of broad areas of the market or sector, and as such, track a broad range of securities. An investor who invests in the securities of an index (or who purchases an index mutual fund or ETF) is diversifying their portfolio’s investments across that index. Diversification tends to lower portfolio risk as when one company or segment of the market underperforms, others will usually outperform, thereby making returns more even, more consistent.

Lower fees

Because index investing is passive, the management of an index mutual fund or ETF is more hands-off. That means they usually have significantly lower management fees than their actively managed counterparts. Index funds also tend to have fewer trades than an actively managed fund, which also tends to lower their management costs. And ultimately, lower management fees can help boost your returns.

Potential risk reduction

As we mentioned already, index investing helps investors to diversify, which can help manage portfolio risk. Because an index fund is a broad basket of securities, it helps to minimize risks related to a single company or sector.

In addition, the hands-off approach of index investing helps to eliminate your own investing biases. The buy-and-hold strategy of index investing helps to remove the impulse to try to “time the market” that often plagues a more active stock-picking approach.

Are there any disadvantages to index investing?

Despite the low-cost and diversification advantages of index investing, some believe that index funds should be viewed with caution. To begin with, index investing ignores other investing strategies, like growth, value and quality investing, which may be more suitable for some investors, depending on their goals and risk tolerance.

If you’re invested solely in index funds, it could prevent you from taking advantage of opportunities elsewhere. Say you needed to withdraw money from your trading account to jump on another investment opportunity. But what if the market was significantly down right when you needed that money? If you were entirely invested in an index fund, you would have to liquidate fund units at that lower valuation to convert them to cash. If you held individual holdings instead, chances are that some securities would be up and others would be down, and you could pick and choose the security to sell to accommodate your withdrawal.

If you follow an index investing strategy, particularly if you purchase an index fund, you have no control over the individual holdings in the fund. If a stock or bond is included in an index, it’s held in the fund – you have no ability to opt out. There may be a company or sector you want to avoid, which you cannot do in an index fund. Similarly, you may have researched a specific stock that you want to purchase, which you could do only if you have a brokerage account (like at Qtrade).

Some are critical of index investing because many indices are constructed on a market capitalization basis, which means that the largest companies have a corresponding large weighting within the index. As a result, the largest holdings have an oversized impact on the performance of the index. So, even if the majority of stocks or bonds in an index have a good quarter, the weak performance of the largest holdings can bring down the overall performance.

How to choose an index fund

If you want to add an index fund to your portfolio, you’ll need to choose the index you want your fund to track. Indices can be focused on a wide array of factors, including the size of companies (market capitalization), a geographic region, or a sector/industry. There are indices for stocks and for bonds, but also for currencies and commodities.

Once you have the index (or indices) you want to replicate, you’ll need to narrow the field. Most fund companies offer index funds. That’s where your usual investment research comes in.

Qtrade has a number of tools to help you evaluate and choose the right mutual fund or ETF for you:

• How to choose a mutual fund
• How to choose an ETF