Index mutual funds can provide a low-cost way to invest in the stock market. However, they have disadvantages and there are better alternatives.

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

For example, mutual funds that pursue a trading or sector-rotation approach to investing belong in this can’t-win category. Managers of these funds try to out-perform the market by betting on relatively short-term trends, rather than putting their investors in a position to profit near automatically from long-term growth in the economy. This can work, but only for limited periods.

In any one year, the top fund is often run by a market timer who is having his or her proverbial “day in the sun”. In any one decade, however, the top funds are generally run by conservative managers who focus on long-term growth in the economy.

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 that follow this 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, 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.

Beware of buying vaguely described Canadian index funds

Canadian index funds generally follow a well-defined index. But be careful investing in Canadian index mutual 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 fund’s performance and investments to see if they differ from what the prospectus or sales literature would lead investors to expect.

Why we prefer ETF index funds over index mutual funds

1. Generally, ETFs are less expensive to hold. ETFs give you a low-cost way to invest in a narrow market segment. That’s typically cheaper than investing in an index mutual fund with a similar focus. With fees as low as 0.10% a year for ETFs vs. Index mutual funds that can charge you 1% or higher on their funds. ETFs can save you a lot of money and boost your returns over time.
2. ETFs trade on stock exchanges, just like stocks. That’s different from conventional mutual funds or index mutual funds, which you can only buy at the end of the day at a price that reflects the fund’s value at the close of trading.

Do you still hold index mutual funds in your portfolio? Have they been profitable for you? Are the index holdings diversified or were they concentrated in a single market sector? Share your experience with us in the comments.