Index funds are essentially a passive portfolio of investments that mirror the index from which they are derived. A TSX 60 Index fund, for example, would hold the 60 different stocks that compose the TSX 60 index. Because the portfolio is passively managed, the management expenses (MERs) are lower on Index Funds compared with other actively managed equity funds. Like any investment, they have their pros and cons. Index funds are more volatile (risky) than a typical managed equity portfolio but less so than sector specific funds. They generally have lower MERs but do have a cost, so their performance doesn't exactly match the underlying index.
Over the years, we have heard a lot about index funds in the media. Starting in the 1999 calendar year, a great deal of press was devoted to Index Funds. In 2000, the hot topic in the press was Exchange Traded Funds (ETFs.) With the decline in the major indices in 2001, however, investor interest in both waned. Sadly, but as usual, investors piled into these funds at close to their highs, and then sold as indices fell much more than the average mutual fund. Interestingly, by 2004, 5 years after the boom in index fund investing, the average canadian actively managed fund had outperformed the index. See Mutual Fund Reporter, Issue 207. Since then there have been periods of over- and under-performance by both actively managed and passively managed funds.
Interestingly, while there are many proponents of index funds, there are also many who point out that the world would make no sense if absolutely everyone invested passively in index funds and there were no active investors. The efficient market hypothesis suggests that security prices reflect all known information. If that were so, no one could ever profit by buying one undervalued security and selling an overvalued one because the current prices already reflect complete and true value. Essentially the efficient market hypothesis says that if you saw a $10 bill lying on the sidewalk, you wouldn't pick it up, since if it was really there, someone else would have picked it up already. We believe that active managers can identify market opportunities and act on them. In fact, active investors buying and selling action actually creates the market in which index funds can then exist.
In general, index funds should have higher after tax returns than normal actively managed funds, as they don't trade their portfolios. However, since many of your fellow index fund unitholders may be market timers and not buy and hold investors, some index funds can actually have very high distributions, 2000 was a particularly bad year. As reported in the Toronto Star, one investor in the Royal US premium index fund had a taxable gain distributed of $89,000, resulting in his Old Age Security payments clawed back because his net income topped $55,000 for 2000.
We see both the pros (low MERs, and little ongoing monitoring required) of index investing and the cons (higher risk, tax implications, and performance divergence). In the end, even with index funds, it is appropriate to diversify. We continue to feel that indexing a portion (up to 20%) of your portfolio can make sense because of the fee savings over the very long term, however there are also risks to consider.
Contact us for advice on how index funds might fit with your portfolio. We are pleased to report that your ScotiaMcLeod account offers you in excess of 30 different Index Funds, and dozens of ETFs from which to choose, including many recognizable names. Index funds from the Scotia Funds family do offer the benefit of low $500 minimum purchase amounts or $50 in PAC plans and as always, with the benefit of no loads.
ScotiaMcLeod is a division of Scotia Capital Inc., member of CIPF.
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