You've probably heard at least one financial adviser say that you shouldn't invest in index funds. "Our firm can beat them. Just look at the returns from these great funds." The onscreen charts seem to scream one message. Only fools buy indexes.
That's like a 15th-century merchant selling giant grappling hooks. "The world is flat. Sail off the edge and these will save your ship."
We know, however, that the world isn't flat. Most actively managed mutual funds don't beat indexes, either. The SPIVA Canada Scorecard says the S&P/TSX composite index humbled 80 per cent of actively managed Canadian equity funds during the five years ending 2014.
Canada's mutual funds focused on global stocks did even worse. The international indexed benchmark beat 86.8 per cent of them. The S&P 500 index of U.S. stocks (measured in Canadian dollars) beat 97.1 per cent of its actively managed counterparts over the past five years. Yes, some funds beat the market. But studies show that today's winners, more often that not, become tomorrow's riptide victims.
Building a diversified portfolio of index funds has never been easier – or cheaper. In fact, you can get all the diversification you need with just three Vanguard ETFs. Each trades on the Toronto Stock Exchange, eliminating the costs (and hassles) of currency conversions. Just open a brokerage account and you're ready to sail.
Vanguard's FTSE Canada All Cap Index ETF (VCN) should be the first port of call. It's made up of 240 Canadian stocks. Some are large, some are medium sized and some are small. Its management expense ratio is just 0.11 per cent a year. By comparison, the typical active Canadian fund costs about 2.4 per cent. Higher costs become grappling hooks that function like anchors.
Vanguard Canada offers exposure to the rest of the world's stock markets in a single ETF. The FTSE All World ex Canada Index ETF (VXC) contains 3,058 global stocks. Countries are weighted based on market capitalization. For example, the United States makes up about 50 per cent of global capitalization. So roughly half the global index comprises U.S. stocks. Thirty-seven other countries are also represented with large, medium-sized and small-cap equities. The fund's MER is just 0.27 per cent.
Finally, investors should have exposure to bonds. Yes, bonds are boring. No, they don't perform as well as stocks – especially when markets rise. But they add diversification – something greatly needed when stock markets sink. When stock prices fall, bonds often rise.
Vanguard's Canadian Short Term Bond Index ETF (VSB) contains 279 bonds, including government and investment-grade corporate debt. Each bond matures within a five-year period. When a bond matures, a new one takes its place. This kind of turnover increases the odds of beating inflation. When interest rates rise, the newly purchased bonds, within a short-term bond index, earn higher interest rates.
Investors should annually rebalance their three index funds. Sell a bit of what's hot to buy a bit of what's not. If stocks have beaten bonds by the end of the year, sell some stock proceeds to add to your bonds. And if bonds are the winner, sell some of the proceeds to add to your stocks.
But how much money should you put in each index? One simple solution is a three-way split. Investors with a higher risk tolerance could settle for fewer bonds. Conservative investors could keep their bond exposure high.
One thing is certain. Investors shouldn't speculate. Stick to your set allocation. Increase your bond allocation as you age, if you like. But don't try to guess which index will leave the rest in its wake.
Nobody can predict, with any level of consistency, whether one index will outperform another in any given year. If you think someone can, I have a huge grappling hook that I may be able to sell you.