When it’s a question of ETFs vs index funds, which ones work best in your portfolio?

When considering ETFs vs index funds for your portfolio, it’s important to have a strong understanding of each.

Exchange-traded funds hold baskets of stocks that represent stock indexes. ETFs are set up to mirror the performance of a stock-market index. Generally, they offer significantly lower fees than mutual funds. They can save you a lot of money and boost your returns over time.

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Index mutual funds also invest to match the performance of a market index, such as the S&P/TSX 60. Index mutual funds do show better long-term performance than about two-thirds of actively-managed mutual funds with long-term track records. However, their fees are generally higher than ETFs investing in the same index.

ETFs vs index funds: Advantages of Canadian index funds

Canadian index ETFs show better long-term performance than most index mutual funds. That’s partly because index fund fees run as low as 0.10% of assets per year, compared to an average 1.0% for index mutual funds.

One big advantage of index mutual funds—if you want to invest in them—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. These funds’ managers try to outperform the market by betting on relatively short-term trends. This can work in any one year, say. But in any one decade, the top funds are generally 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 low-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).

ETFs vs index funds: An ETF investment can be a great low-fee way to hold shares in multiple companies with a single investment

An ETF investment is one of the most popular and most benign investing innovations of our time. ETFs are a little like conventional index funds, but with two key differences.

First, ETF investments trade on a stock exchange throughout the day, much like ordinary stocks. So you can buy them through a broker whenever the stock market is open, and generally you pay the same commission rate that you pay to buy stocks. In contrast, you can only buy most conventional mutual funds at the end of the day. What’s more, commissions vary widely, depending on negotiations with your broker or fund dealer.

Second, the MER (Management Expense Ratio) is generally much lower on ETFs than on conventional mutual funds. 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 “passive” fund management, in contrast to the “active” management that conventional mutual funds 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 & Poors). 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 change. They don’t attempt to pick and choose which stocks they think have the best prospects.

ETFs vs index funds: Beware of buying vaguely described Canadian index mutual funds

Canadian index mutual funds generally follow a well-defined index. But be careful investing in Canadian index funds that show wide disparities between the fund’s portfolio and the investments that the sales literature describes.

It’s often hard to find out much about who is making the decisions, what sort of record they have, and what sort of investing they prefer. We always take a close look at an index mutual fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect.

Have you wondered about ETFs vs index funds? Do you hold either in your portfolio? Share your experience with us in the comments.

This article was originally published in 2016 and is regularly updated.