Discover the pros and cons of index investing with both mutual funds and exchange traded funds (ETFs)

Index investing has both advantages and disadvantages. However, is index investing really a good overall strategy for growth investors?

In this article we look at both mutual funds and ETFs for index investing consideration.

Are mutual funds or ETFs worthy buys for index investing?

Index mutual funds are among the few good financial innovations to come along in the past few decades.

Index investing mutual funds do show better long-run performance than more than half of all 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.

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.

Index mutual funds can provide a low-cost way to invest in the stock market. However, for the best long term returns, we 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. Or, invest in mutual funds or ETFs that follow our approach.

If funds invest as we advise, sticking with well-established, mostly dividend-paying companies and spreading their assets out across most if not all of the five main economic sectors, they will tend to lose a lot less than the market indexes in periods when the indexes fall sharply. That’s because big market slides are particularly hard on the hottest, most popular stocks of the preceding market rise. Investing as we do leads you to avoid excessive investment in the hot stocks.

Index mutual funds or ETFs, in contrast, tend to 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. That occurs from time to time, especially in the Toronto market, with periodic resources exposure.

Index investing: Advantages of Canadian index funds

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.

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 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).

Reasons why investors like index investing through exchange traded funds (ETFs)

The MERs (Management Expense Ratios) are generally 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 this “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.

This traditional, passive style also keeps turnover very low, and that in turn keeps trading costs for your ETF investment down.

Do you see growth opportunities through index investing or do you think that following an index is too limiting?