Index funds? What a mistake.The trouble here is not the concept of index investing. We can argue forever about whether it's better to own actively managed funds or funds that track the major stock indexes, but indexing does makes sense.
Unless you use index funds. Costly to own, they're a distant second choice behind exchange-traded funds as a way to put the indexing strategy to work.
The vast majority of index funds are offered by the big banks, which tend to have reasonable fees on their fund products. Index funds are a glaring exception, though. Really, they're so expensive that you have to question whether they're worth holding at all.
The whole point of indexing is that if you can make what the index makes and pay only a pittance in fees, then you can do better than most actively managed funds. The average large Canadian equity fund has a management expense ratio in the area of 2.5 per cent; compare that to 0.17 per cent for the most popular ETF in Canada, the i60, and an average 0.94 per cent for Canadian index funds sold by the Big Five banks.
Let's assume the indexes tracked by the i60 and the index funds all make a 10-per-cent annual return before fees are applied.
After fees, the bank index funds leave you with an average 9.06 per cent and the i60 gives you 9.83 per cent. Repeat this over a period of 10 years and the i60 makes you an extra $1,735 on a $10,000 investment.
Bank-sold index funds charge more and deliver less, but they do have some distinct benefits.
For example, they reinvest dividends for you at no cost, whereas dividends paid by ETFs collect as cash in your account and you'll have to pay commissions to reinvest them. Most importantly, index funds are sold on a no-load basis so there's no cost to buy or sell.
ETFs are listed on stock exchanges and trade like stocks, so you'll need a brokerage account to buy them and you'll have to pay commissions to buy and sell. An on-line broker's cost for trading up to 1,000 shares of most stocks would typically range from $25 to $30.
Don't get hung up on the commissions for buying ETFs, though. As a rough rule of thumb, the cheaper MER of an ETF can offset the purchase commission at an on-line broker in a single year if you invest $4,000 or more.
Here's the math: We start with a $4,000 investment in i60s and Canadian equity index funds, both of which make a gross 10 per cent. The i60s have a net return of 9.83 cent, which means you make $393; the bank index fund nets 9.06 per cent, which amounts to $362. The difference is $31, more than enough to cover the buy commission at any on-line broker.
A similar face-off between RRSP-eligible U.S. index funds and the comparable TSX-listed ETF called the i500 yields a similar result. Bottom line, the cheaper MERs of ETFs can quickly nullify trading commissions for larger investments.
One area where ETFs have a huge advantage over index funds is the variety of stock indexes they follow.
Index funds give you access to just over a half-dozen global indexes, while ETFs tap into dozens of Canadian, U.S. and global indexes. ETFs also offer exposure to specific sectors and countries.
The one area where index funds can make sense is if you want to make small periodic investments. You can easily set up a monthly contribution plan for as little as $25 to $100 a month, depending on the fund company.
Don't get involved with an index fund before comparing MERs, though. It's a given that you're going to pay a hefty fee by indexing standards, but you can still save significant amounts of money by looking at certain fund families.
For example, Altamira has a series of index funds with MERs ranging from 0.53 to 0.75 per cent, which is a bargain compared with between 0.84 and 1.4 per cent charged by the big banks for their mainstream products.
A better deal is the e-fund series offered by Toronto-Dominion Bank through the website http://www.tdefunds.com or its TD Waterhouse on-line brokerage arm. The e-version of TD Canadian Index has an MER of 0.31 per cent, which is just 0.06 of a percentage point more than a TD-sponsored exchange-traded fund called TD S&P/TSX Composite Index Fund.
An unfair aspect of the indexing versus active management debate is that the indexing side too often gets let off easy on the matter of fees. It's almost as if low fees are a given in index investments, which clearly isn't true.
If you want indexing to be all it can be, then remember that fees matter. In this context, index funds are also-rans.
Costs of indexing
The vast majority of index funds are offered by the big banks.
As of Dec. 31, 2004
| Fund name | Asset class | Assets($million) | MER% |
| Altamira Precision Cdn. Index | Canadian Equity (Pure) | $101.5 | 0.54% |
| BMO Equity Index | Canadian Equity (Pure) | 379.9 | 1.04 |
| CIBC Canadian Index | Canadian Equity (Pure) | 838.6 | 0.96 |
| National Bank Canadian Index | Canadian Equity (Pure) | 17.4 | 1.14 |
| RBC Canadian Index | Canadian Equity (Pure) | 437.9 | 0.84 |
| Scotia Canadian Stock Index | Canadian Equity (Pure) | 292.5 | 1.01 |
| TD Canadian Index | Canadian Equity (Pure) | 709.0 | 0.85 |
| TD Canadian Index - E | Canadian Equity (Pure) | - | 0.31 |
