What are index funds and what are the main benefits (and risks) for investors?

What are index funds? Index funds are mutual funds or exchange-traded funds (ETFs) that invest to equal the performance of a market index.

Here are the types of index funds to be aware of, and tips for making index funds a successful part of your portfolio.

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What are index funds: Mutual funds

Index mutual funds are among the better financial innovations to come along. These are specialized mutual funds that invest so as to come close to equaling the performance of a market index such as the S&P/TSX 60.

Index mutual funds do show better long-run performance than many actively managed mutual funds with long-term track records. That’s partly because index fund fees run around 1.0% of assets per year, compared to 2.5% or more on many broker-sold mutual funds.

As mentioned, one big advantage of index mutual funds is that they can help you avoid the risk of choosing a fund with a management style that virtually guarantees below-average long-term performance. These styles include asset allocation and sector rotation.

One risk of index mutual funds is that they hold the biggest stocks by market cap. That means that they might load up on the hottest, most popular stocks as they rise. That’s because, as these stocks rise, they make up a rising proportion of the index. When the indexes go to extremes, so do the index funds.

Index mutual funds can provide a low-cost way to invest in the stock market. However, for the best long-term returns, we still think you are better off to build a portfolio of well-established companies, spread out across most if not all of the five main economic sectors.

What are index funds: ETFs

Exchange-traded funds (ETFs) are set up to mirror the performance of a stock-market index or sub-index. They hold a more-or-less fixed selection of securities that represent the holdings that go into the calculation of the index or sub-index.

Exchange-traded funds trade on stock exchanges, just like stocks. Investors can buy them on margin or sell them short. These funds have gained popularity among investors, mainly because many ETFs offer very low management fees.

Typically ETFs are more tax-friendly and cheaper than mutual funds, even though they may hold more or less the same stocks.

There are benefits to ETFs  trading like stocks. It means that investors can buy or sell during normal trading hours. They can also put stops or limits on their investments. However, every time an ETF is bought or sold, you pay a commission. Many investors already know this process, which is the same as buying or selling stocks. But in the end, these commissions mean ETF investing can get more costly if you make a lot of buys and sells.

What are index funds good for? Three advantages index funds can bring to your investment portfolio

• One big advantage of index funds 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.
• Another advantage of index funds is that they can give investors with limited funds a low-cost way to get some stock-market exposure.
• And finally index funds typically have low annual fees.

Bonus tip: Watch out for these mutual fund mistakes

Avoid fund managers who trade heavily: Some of the most dangerous funds are those run by managers who honestly believe they can increase their performance by frequent in-and-out trading. Many of these managers fail to realize how close their mutual fund’s performance comes to disaster each year, until disaster finally strikes.

Avoid buying vaguely described funds: Get rid of mutual funds—or ETFs for that matter—that show wide disparities between the mutual fund’s portfolio and the investments that the sales literature describes. Many mutual fund operators describe their investing style in vague terms.

Avoid buying funds that trade in derivatives: In the long run, derivatives trading is what mathematicians refer to as a “negative-sum game”: one player’s gain is another’s loss, minus commissions and other costs. In the end, trading derivatives costs you money.

Some funds are set up to profit by trading in derivatives, but other market participants can also access that information. So, things are unlikely to work quite the same way for the mutual fund’s performance over the next five years.

What role are index funds playing in your portfolio, and have you found them to be safer than your other investments?

Index funds can be a great way to get started with investing, but they can lead to big expenses if you aren’t careful. What do you look for if you’re adding an index fund to your portfolio?