Well, because index funds are similar to mutual funds and ETFs, many investors tend to use them for retirement. The easiest way to explain them is that they are a type of ETF or mutual fund that is made to track or match the components of one financial market index.
How Index Funds Work
As we mentioned above, index funds are types of mutual funds and ETFs (Exchange Traded Funds). There are different types of index funds, and each one mirrors a different type of index. Each index has different stocks in it so instead of investing in one stock at a time, you are investing in multiple stocks. Many people prefer this because then your money is diversified instead of being invested all in one place.
This type of investing is less stressful and can be less risky than investing in just one stock at a time. This is because, when you invest in individual stocks, you are trying to beat the market. Index funds just mirror it, which, while the return might not be as significant, the risk is less. This is sometimes referred to as passive investing.
Low-Cost Index Funds
While low-cost index funds may sound like the index fund costs less money, they actually refer to the fees related to the index fund. Many investors like to choose these because then they get a better return. The more money that is invested directly into the index, the more it reduces their overall cost. They are also really easy to get. You can purchase them directly from your financial institution.
One Fund Solutions
These types of index funds require no effort on your part. They are already designed to be either conservative (low risk and considered to be income-focused), medium risk (balanced) or high risk (growth). There are also no commission fees associated with one-fund solutions, which is great. This puts less pressure on you as the purchaser. These types of indexes are considered to be passively managed index funds.
Individual Index Funds
With individual index funds, they can be purchased and combined, allowing you to create your own diversified portfolio. These stock index funds are often purchased by investors with a higher risk tolerance.
Some investors will use a fund manager to create a fund for them with these individual indexes. These can cost a bit more because they are actively managed index funds, but they can give you a good return on your investment.
How to Purchase an Index Fund in Canada
If you’re looking to buy index funds in Canada, it’s actually very simple. You can go through your financial institution, such as a bank or credit union, and they can help to set you up with the index fund of your choice. If you don’t want to do it that way, you can also go through a brokerage.
Before you go into purchase an index fund, though, you should have an idea of what index fund you want to invest in. Are you looking at a “one-fund solution?” Or are you going to diversify your profile a bit and invest in multiple index funds? There is plenty of research you can do to see which fund is the best for you, but there are some that are more popular than others, as well.
Best Index Funds to Invest In
As we mentioned, it can be really difficult to decide which index fund to start investing in. There are so many to choose from, and it can become overwhelming. Here are a few of the best ones to get you started. Before you choose, though, it’s important to understand that index funds mirror the performance of the underlying index, known as the benchmark index.
BMO S&P/TSX Capped Composite Index ETF
This is a great index fund for a beginner to get started on. It has a low fee cost of 0.06%, so essentially, it costs $6.00 for every $10,000 you invest. It also closely follows the S&P/ TSX Capped Composite Index, as the name suggests. This means that it contains the largest Canadian companies that are trading on the TSX, also known as the Toronto Stock Exchange. While that may not sound like much, it actually contains 95% of the Canadian total equity market. These factors not only make it a great investment for beginners, but it is also great for experienced investors. The size of this investment makes it quite stable and works well if you intend to buy the index and hold onto it for a while.
iShares S&P/TSX 60 Index Fund
Another index fund that is great for beginners, as well as long-term investors, is the iShares S&P/TSX 60 Index Fund. As you may have already guessed, it follows the S&P/TSX 60 market index and, as the name suggests, it contains 60 of the biggest stocks (by market cap) on the TSX.
Interesting fact: this index is the oldest Canadian ETF on the market. The fees on this index are a bit higher than the Capped Composite Index ETF, with management expense ratios (MER) of 0.18%, costing only $18 for every $10,000 invested.
Vanguard FTSE Canada All Cap Index ETF
The Vanguard FTSE Canada All Cap Index ETF is also largely invested in the index. That being said, its stocks are a lot more diversified than the other Indexes we have discussed. This index picks stocks from the FTSE Global Equity Index Series, which holds 98% of the world’s stock market. This allows the index to contain a variety of large, small and mid-cap stocks, not just large-cap companies.
The MER on this index is only 0.05% ($5 per every $10,000 invested), and the diversification of it helps to diversify your portfolio. An index like this isn’t always a first choice for beginner investors because there are more variables involved, but it is often purchased in a mix with other indexes.
Best Low-Cost Index Funds
With low-cost index funds, you can choose between “one-fund solutions” or individual indexes. Here are a few of the most recommended.
One-Fund Solutions
One of the most common ones is the Tangerine Funds. It has a MER between 1.05% and 1.07% ($105-$107 per $10,000 invested), and you can choose the ratio you want.
- Equity Growth Fund – 100% stocks
- Dividend Fund – 100% dividend funds
- Balanced Growth Fund – 50% fixed income and 50% stocks
- Balanced Fund – 40% fixed income and 60% stocks
- Balanced Income Fund – 70% fixed income and 30% stocks
Another one is the TD Balanced Income Fund, which offers 50% fixed income and 50% stocks. The MER on this index is 0.78% or $78 per $10,000 that is invested.
Individual Index Funds
When you are looking into individual index funds, each financial institution has its own that you can choose from. While there are plenty of banks we can choose from, let’s take a look at TD and RBC. You will notice a pattern of Index funds, bond index funds, US index funds and International index funds.
TD
The index funds you can choose from with TD are:
- The TD Canadian Index. This has an MER of just .22 % or $22 per every $10,000 invested.
- The TD Canadian Bond Index. This one has an MER of .72% or $72 for every $10,000 invested.
- The TD U.S Index. This index has an MER of .28% or $28 per $10,000 invested.
- The TD International Index. This one has an MER of .52% or $52 per $10,000 invested.
RBC
The index fund options offered by RBC are as follows:
- The RBC Canadian Bond Index. This has an MER of .71% or $71 per $10,000 invested.
- The RBC Canadian Index Fund. This has an MER of .66% or $66 per $10,000 invested.
- The RBC U.S Index Fund. This has an MER of .66% or $66 per $10,000 invested.
- The RBC International Index Currency Neutral Fund. The MER is .61% or $61 per $10,000.
What Brokerages Allow You to Purchase Index Funds?
As we mentioned, major banks and credit unions allow you to purchase index funds. You can also purchase index funds through brokerages, even online ones like Wealthsimple. If you go through Wealthsimple or a similar brokerage, they will help you create a diverse portfolio that can help you achieve your goals with lower fees.
S&P 500 Index Fund and Purchasing in Canada
Even if you don’t know a lot about the stock market or index funds, there is a good chance you have heard of the S&P 500. While the S&P 500 is a popular index, you actually can’t invest in it in Canada. However, you are able to invest in the stocks that make up the S&P 500 index. You can also invest in Canadian indexes that follow the S&P 500’s performance.
We have already mentioned that index funds are a type of mutual fund and ETF, so you will find both kinds of indexes. There are both types of these indexes in Canada that follow the S&P 500. Mutual funds are better for long-term investments, whereas index ETFs are better if you don’t plan on holding onto them for a long period of time. The ETFs also have lower MER fees. This is true not only for indexes that follow the S&P 500 but also for all indexes.
Index Funds and Taxes
When you are investing in any kind of stock, including many index funds, it is important to remember that you have to pay taxes on the earnings that you receive from these investments. In some cases, it may be considered income, in others, you may be charged a capital gains tax. Whether the index is an ETF or a mutual fund doesn’t have a lot of bearing on how you claim them on your taxes.
That being said, it can be confusing to involve your investments in your taxes. The CRA determines what kind of tax you pay on your earnings based on if it is considered business income or not. If investments are a full-time income for you and you are considered to be self-employed, then what is affected is when you pay income tax. The date for self-employed taxes is June 15 instead of April 30.
Are Index Funds or Index ETFs Better in Canada?
While both can be good choices, for most Canadians, Index ETFs are the better choice. This is because they have:
- Lower management fees
- Broader diversification
- Greater tax efficiency
That said, index funds are sometimes preferred because you can have automated deposits that are commission-free. This gives you smaller and more frequent investments.
How Often You Should Rebalance an Index Fund Portfolio
When it comes to index investing, you should rebalance your index fund portfolio once per year. Alternatively, you should also rebalance whenever your asset allocation drifts from your target by more than 5%. When it comes to rebalancing, there are 3 different strategies.
Time-Based: With this strategy, you rebalance once per year. This helps maximize tax-sheltered contributions and tax-loss harvesting. However, some people choose to do this quarterly and semi-annually instead.
Drift-Based: This strategy is the 5% rule. When your esst slips from a specific threshold by 5%, you choose to rebalance instead.
Accumulation Phase: For those who are continuously contributing to their account, a rebalance may not even be required since it’s continually happening throughout the year. You may just need to shift a few things around to stay in the percentage that you like.
The Account That is the Most Tax-Efficient for Index Funds
When building your index fund portfolio, registered accounts are the most tax-efficient place to hold them. This investment approach allows you to defer or avoid taxes, allowing you to invest more. However, even for passive investors, there are still going to be transaction fees and management fees.
TFSAs: Tax-Free Savings Accounts allow you to avoid paying tax on any interest that you earn. Even with discount brokers, your long-term growth is tax-free, no matter which specific index you invest in.
RRSPs: With Registered Retirement Savings Accounts, traditional mutual funds are the most common type of investment. However, choosing index funds is also doable in RRSPs. It allows you to defer your taxes until you retire, when your marginal tax rate is likely to be much lower.
FHSAs: First Home Savings Accounts allow you to avoid paying income tax on any contributions you make into the account. As long as the funds are used to purchase your home, you won’t have to pay any tax. If you don’t use them within 15 years, they can be transferred to an RRSP or withdrawn with a penalty.
Are Currency-Hedged Index Funds Worth It?
For the vast majority, currency-hedged index funds are generally not worth it for long-term equity investors. However, they are great investment vehicles for retirees as well as those who are focused on reducing portfolio volatility. Some other situations where they may be worth it include:
- Fixed Income Investments: Since individual holdings like bonds are inherently low risk, any currency swings can wipe out your gains or eat into your stability. ETF purchases for foreign bond ETFs and hedging them back to Canadian is highly recommended.
- Short Time Horizons: Even with passive index investing, currency-hedged index funds help you get predictable returns, which is needed when you’re nearing retirement.
- A Strong Canadian Dollar: When hedging your funds in foreign currency against the Canadian dollar, having a strong dollar is a good time to hedge.
Norbert’s Gambit for US Index Funds
When investing in a specific market index, even if it’s your first index fund, lower management fees are important. However, you can still accumulate higher fees in the form of foreign exchange fees. This can be avoided using Norbert’s Gambit.
This strategy allows you to bypass high brokerage exchange fees, which are often between 1.5% to 2.5%. By buying and selling a dual-listed stock, you’re able to convert your US dollars to CAD dollars at a nearly 1:1 ratio, keeping costs low.
All-In-One Index Funds
All-in-one index funds, also known as asset allocation ETFs, allow for broad diversification with thousands of global stocks from different geographic regions. This takes funds from one sector, or more than one, and offers steady returns by putting them into one single, automated portfolio.
MER Vs Trading Expense Ratios
When it comes to your investment platform, especially if you purchase expensive actively managed funds, you need to consider both Management Expense Ratios and Trading Expense Ratios. As an index investor, you’ll notice that these fees are charged by an investment fund manager.
The MER represents the total percentage of a fund’s assets that is used to pay for ongoing operational costs. This fee is automatically deducted from your funds returns and includes the management fees, operating expenses, taxes and trailer commissions.
The TER measures the costs associated with buying and selling assets within the fund. This fee is not part of the MER and includes brokerage commissions as well as applicable taxes.
Best Couch Potato Portfolios for Canadians
Couch potato portfolios are also known as all-in-one asset allocation ETFs. These provide global diversification since all the stocks are combined into one ETF. These contain stocks from some of the largest companies and help create financial independence with their instant diversification. It also gives you access to the whole market with a broad range of investments; you don’t need to get investment advice on or look for their past performance.
Here’s a list of some of these, along with their ticker symbol.
- iShares Core Equity ETF Portfolio (XEQT)
- Vanguard All Equity ETF Portfolio (VEQT)
- BMO All Equity ETF (ZEQT)
- iShares Core Balanced ETF Portfolio (XBAL)
- BMO Balanced ETF (ZBAL)
- Vanguard Conservative Income ETF Portfolio (VCIP)
- iShares Core Income Balanced ETF Portfolio (XINC)
Best Canadian Index Funds for FHSA Accounts
Depending on when you choose to purchase a home, there are different ETFs that are your best choices. If you’re looking to buy within the next 5 years, then some good options are:
- CI High Interest Savings ETF (CSH)
- BMO Money Market Fund (ZMMK)
If you’re planning on purchasing later than 5 years, then some other great choices are:
- Vanguard Balanced ETF Portfolio (VBAL)
- iShares Core Growth ETF Portfolio (XGRO)
Index at Canadian Banks Vs. Discount Brokers
Whether you choose to invest in indexes with Canadian banks or discount brokers, there are still going to be some fees you need to pay. You also need to pay attention to how convenient it is to use them. Some offer robo advisors, which can make the investing process much easier. Your average return and the ETF facts don’t change. You can also invest in MSCI World Index and Aggregate Bond Index ETFs with both.
ESG and Socially Responsible Index Funds in Canada
With so many different indexes out there, you’re able to align what you invest in with your values. This is why many people choose to invest in Environmental, Social and Governance Index Funds, as well as Socially Responsible Investment Index Funds. Some of the best ones out there include:
- iShares ESG Aware MSCI Canada Index ETF (XESG)
- BMO MSCI Global ESG Leader Index ETF (ESGE)
- iShares ESG Aware MSCI EAFE ETF (XEF)
- NEI ESG Canadian Enhanced Index Fund
- Fidelity Climax Leadership Funds
Are Index Funds the Right Choice for You?
The thing with index funds is that you can invest in them long-term or short-term. Some people choose to use them for retirement, whereas others include them in their investment portfolios and trade them like stocks. These differences will determine whether you are looking at a mutual fund index or an ETF index. The thing is, though, you can make a return on either. You are also able to invest in index funds by yourself, and there are no investment minimums.
That being said, because not all index funds are the same, you are able to speak to a broker or your financial institution for some recommendations. Whatever you choose to do, index funds are just one of the many ways you can grow your money while investing in the stock market.
Final Thoughts
In Canada, there are plenty of index funds to choose from, including the Dow Jones Industrial Average fund. The ones we mentioned are just a few of your choices. As well as these funds, though, you can choose between actively managed funds (charge trading commissions), passive investment strategies, index mutual funds, ETFs, and the different investment accounts you want to invest in these Canadian index funds.
When it comes to investing, you can also choose to use an online brokerage account or invest with financial advisors. Some Canadian investors choose to do both based on the particular index fund they’re investing in and the strategy they want to use. Financial advisors can do things such as fractional shares with certain mutual funds and shares, which can’t always be done using an online brokerage. No matter what individual funds you choose to invest in or ETF trades you choose to make, these investment options can help you reach your financial goals.
