Editors note: Advertisers are not responsible for the contents of this site including any editorials or reviews that may appear on this site. For complete and current information on any advertiser product, please visit their Web site.
An index fund is a type of mutual fund that’s designed to passively track a specific stock market index. This article explains why you should invest in index funds, and where to find the best index funds in Canada.

If you’re a savvy investor, you’ve undoubtedly heard of “index funds.” But what the heck is an index fund and why would you want one in your portfolio? We answer all your burning questions about index funds in Canada.

What is an Index Fund?

An index fund is a type of mutual fund that’s designed to passively track a specific stock market index, such as the S&P/TSX Composite Index (the benchmark Canadian index) or the S&P 500 Index in the United States. Index funds allow investors to mimic the performance of one or more of these indices – typically at a much lower cost than an actively managed mutual fund.

Index funds are well suited for individual investors who don’t have the time, skill, or patience to analyze and manage a portfolio of individual stocks or actively managed mutual funds. Furthermore, because of the relatively low cost and broad diversification that index funds offer, passive investors can typically outperform active investors over the long term.

How an Index Fund Works

Index investing is often referred to as “passive investing.” It’s passive because rather than having a fund manager exercising his or her own judgement to determine which stocks to buy or which methodology to follow, the fund manager simply creates a portfolio with holdings that mirror the stocks or bonds of a particular index. The idea is to hold every security in the benchmark index and then match its performance.

Passive investors don’t try to “beat the market.” Instead, they create a portfolio of index funds that try to mirror the market – specifically, by buying stocks of every company listed on an index, with the goal of matching the overall performance of the entire index. Such a strategy can help balance the risk in an investor’s portfolio, as market ups and downs will be less tumultuous across an index compared to individual stocks.

Brief History of Index Funds

Vanguard founder John Bogle, also known as the father of index investing, started the first index fund in 1975. This fund, now known as the Vanguard 500 Index Fund, tracks the S&P 500 and has grown its net assets to $492.2 billion (July 31, 2019). Today, index funds make up half of U.S. stock fund assets.

Index funds have grown in popularity since John Bogle made them famous. Now there’s an index and a corresponding index fund for practically every financial market across the globe.

I mentioned the S&P/TSX Composite Index in Canada, and the S&P 500 in the U.S. Other popular indexes include:

  • Dow Jones Industrial Average (DJIA) tracks the 30 largest U.S. firms.
  • Nasdaq Composite tracks more than 3,000 technology-related companies.
  • CRSP US Total Market Index representing large-, mid-, small- and micro-capitalization stocks in the U.S.
  • MSCI EAFE consisting of foreign stocks from Europe, Australasia, and the Far East
  • Bloomberg Barclays Global Aggregate Canadian Float Adjusted Bond Index following the broad Canadian bond market

There are also many subsets of these indexes. For instance, an index fund tracking the Nasdaq-100 would invest in the 100 largest foreign and domestic companies listed on the Nasdaq Composite Index.

Indexes may use one of two strategies to construct the index. One method is called cap weighting, which takes a company’s market price and the number of outstanding shares to determine the percentage weighting of that company in the index. The larger the company, the larger the weighting in the index. The second method is called equal weighting, and with this strategy, every company, regardless of its size, will be represented equally in the index.

The index may “rebalance” once per quarter to reflect movements in the market (share price appreciation or declines). It also may ‘reconstitute’ its index once a year, meaning it drops certain companies that no longer meet certain criteria, or adds new companies who now meet the criteria.

What that means for index funds that track these market indexes is they will also need to rebalance and reconstitute along with the index to continue matching its performance and minimize tracking error.

Index Fund Facts

  • An index fund is a portfolio of securities designed to mirror the make-up and performance of a particular stock or bond market index.
  • Index funds typically have lower MERs than actively managed mutual funds.
  • Index investing is often referred to as passive investing.
  • Index funds are designed to deliver market returns, minus a small fee.
  • Index funds should outperform actively managed funds over the long term due to lower fees and broader diversification.
  • Index funds help balance risk in an investor’s portfolio.

Index Funds vs. Actively Managed Funds

While actively managed mutual funds attempt to outperform their benchmark by picking winning stocks and timing their investments, passively managed index funds sit back and let the market do its thing. The three main principles are:

(1) markets rise over time (the stock market is up more than it’s down)

(2) it’s nearly impossible to predict which stocks will outperform and

(3) that fees eat into investor returns, so it’s best to keep them as low as possible.

Index Funds in Canada Have Lower Fees

Active fund managers need to pay for their research, analytics, fund managers, marketing, and an army of advisors to sell them in the distribution channel. Canada, in particular, has a problem with fees. The latest research from Morningstar’s sixth Global Investor Experience Study gave Canadian investors a ‘below average’ grade for fee experience. It showed that the average MER for an actively managed equity mutual fund was 2.28%.

A lot goes into a fund’s expense ratio, including operating expenses, marketing, transaction fees, and accounting. More importantly, Canadian investors typically pay a 1% embedded trailing commission for equity funds and 0.50% for fixed-income funds.

Index funds, on the other hand, have little overhead compared to their actively managed counterparts. There’s no need for research and analysis, since they’re just replicating an existing market index. They incur fewer transactions and trading costs, since they’re not timing the market and moving in and out of securities.

The result is that index funds typically cost one-third to one-half the cost of an actively managed mutual fund. That’s more money in the pockets of investors each and every year.

Think of fees as the ultimate investing handicap. If a stock market index returns 8%, an investor tracking that index will see returns very close to 8% (the market return, minus its fee). An actively managed fund that charges 2.28% needs to outperform the market by 2% to make up for its higher fee.

Higher Returns

Looking for more proof that low fees lead to higher returns? I looked at Canada’s big five banks and compared their expensive, actively managed Canadian equity funds to their low-cost Canadian index funds to see how they performed. Here are the results from August 2009 – August 2019:

FundType of FundMER10-year Annual return
TD Canadian Index e-seriesIndex fund0.33%7.01%
TD Canadian Equity FundMutual fund2.17%5.96%
RBC Canadian Index FundIndex fund0.66%6.50%
RBC Canadian EquityMutual fund1.89%5.40%
Scotia Canadian IndexIndex fund1.01%6.28%
Scotia Canadian GrowthMutual fund2.09%4.91%
BMO Canadian Equity ETFIndex fund0.94%5.94%
BMO Canadian Equity FundMutual fund2.39%5.88%
CIBC Canadian IndexIndex fund1.14%6.20%
CIBC Canadian EquityMutual fund2.18%5.20%

As you can see, in every case, the lower-cost index fund outperformed the higher-fee actively managed fund over a 10-year period. This aligns with Morningstar research which suggests that fees are the best predictor of future fund performance – namely, funds with lower fees will typically outperform higher-fee funds.

Active fund managers like to argue that index investors are settling for “average” returns. Why settle for average when you can invest in a mutual fund that will attempt to beat the market?

The academic research is clear, however, that very few fund managers can consistently beat the market over the long term. In hindsight, it’s easy to look back and find a few funds that outperformed for three, five, or even 10-year periods. The challenge for investors is to identify these outperformers in advance – an impossible task. What often ends up happening is a reversion to the mean, where yesterday’s winners become tomorrow’s losers.

Index investors don’t settle for average returns. Instead, they receive market returns. There’s a big difference. The majority (64.49%) of large-cap mutual funds lagged the S&P 500 in 2018. After 10 years, 85% of large-cap funds underperformed the S&P 500, and after 15 years, nearly 92 percent are trailing the index.

Which Index Funds Should I Choose?

If you’re the type of investor who is currently investing in your bank’s actively managed mutual funds but doesn’t have the time or inclination to manage your own portfolio or go with a robo-advisor, our advice is to insist that your bank advisor build you a portfolio of index funds.

TD offers the cheapest set of index funds through its popular e-Series funds. Clients of TD can build a diversified portfolio with just four TD e-Series funds:

Index fund & symbolAllocationMER %
TD Canadian Index – e (TDB900)25%0.33
TD US Index – e (TDB902)25%0.35
TD International Index – e (TDB911)25%0.50
TD Canadian Bond Index – e (TDB909)25%0.51

If you’re not a TD customer, then any of the other big bank index funds can also do the trick. All of them offer a suite of index funds to mimic the Canadian, U.S., International, and Bond markets. All are better options (as you can see in the comparison chart) than their expensive and actively managed counterparts.

Index Funds vs. Index ETF

Index funds are mutual funds that track specific market indexes, such as the S&P 500 or S&P/TSX Composite Index. They’re bought and sold in units at prices set at the end of trading days. An ETF is bought and sold on an exchange just like a stock during normal trading hours. ETFs can be passive or actively managed, with many tracking the same indexes as index funds.

The best place to buy index ETFs is at a discount brokerage. Also known as an “online broker,” it’s a great option for DIY investors who feel confident building their own portfolio and don’t want to pay the high fees attached to actively managed funds. Our top choice is Questrade, where Young & Thrifty readers can get started with $50 in free trades. With no annual fees or fees for purchasing ETFs, you can essentially build an ETF portfolio for $0, making Questrade one of the lowest cost options out there. Use a screener to find all the index mutual funds and ETFs that are available to you through your favourite platform.

If the DIY route is intimidating and you’re not ready to pick stocks yet, you can invest in stocks with the help of a robo-advisor. Robo advisors will automatically create a diversified, balanced portfolio based on your individual preferences, like time horizon and risk tolerance. Plus, they offer fees much lower than a bank or brokerage — saving you even more money in the long-run. If you want to compare robo advisors in Canada head-to-head, read our Complete Guide to the Best Robo Advisors in Canada. But here’s the short story: with its low fees, easy-to-use platform, and exceptional customer service, Wealthsimple is our top choice for the best robo advisor in Canada. Here’s another excellent reason to sign-up: new customers who open and fund a Wealthsimple account with $1,000 will get a $75 cash bonus.

Get $75 when you open a Wealthsimple Invest account!

ETFs in Canada typically charge a fraction of what mutual funds cost – and so although index mutual funds are cheaper than actively managed funds, an index-tracking ETF is even cheaper. For example, Vanguard’s FTSE Canada All Cap Index ETF (VCN), which tracks the entire Canadian market, has a MER of just 0.06%. Here’s a model portfolio you can use to emulate the Canadian Couch Potato strategy – taking a balanced approach to allocation with 40% bonds and 60% stocks:

ETFAllocation %MER %
Vanguard FTSE All Cap Index ETF (VCN)200.06
Vanguard FTSE Global All Cap ex Canada Index ETF (VXC)400.27
Vanguard Canadian Aggregate Bond Index ETF400.09

Alternatively, you can build an even simpler version of the above portfolio with just one ETF. Vanguard, along with other ETF providers such as iShares and BMO, has introduced something called asset allocation ETFs. These products are essentially balanced ETFs, with a blend of domestic and international stocks and bonds.

Vanguard’s VBAL is a balanced ETF with a 40% allocation to bonds and a 60% allocation to stocks:

ETFAllocation %MER %
Vanguard Balanced ETF Portfolio (VBAL)1000.25

RELATED: The best ETFs in Canada for young Canadian investors

Index Investing Amid The COVID-19 Crisis

One knock against passive investing is that, while it’s great to match the market’s performance during a bull market, it’s not as fun to watch your portfolio drop when the outlook turns bearish. Indeed, index investors like me have seen their portfolios take a 20-25% hit in a relatively short one-month period during the COVID-19 crisis.

This is why investing with an appropriate asset mix is so important for index investors. My portfolio consists of one ETF – Vanguard’s 100% global equity ETF called VEQT. Year-to-date it’s down 20.93% (as of April 3, 2020).

Let’s compare that to someone who invested in Vanguard’s VBAL, which represents the more traditional 60/40 balanced portfolio. VBAL is only down 13.28% as of April 3, 2020. It’s held-up remarkably well during this period of extreme volatility.

Active investors might prefer an ETF like Vanguard’s VDY – which represents high dividend yield stocks in Canada – since dividend stocks tend to be wide-moat blue-chip companies that can weather a downturn better than most other businesses. That hasn’t been the case so far this year. VDY is down 22.95% year-to-date.

Don’t let today’s turbulent market dissuade you from starting your ETF investing journey. My advice is to think long and hard about your risk tolerance and the type of losses you’d be willing to accept. Find an asset mix that matches your risk profile, and then build your portfolio with an asset allocation ETF, or 3-4 ETFs that you can maintain and stick with over the long term. You’ve got this!

Final Thoughts

Investors are flocking to index funds for good reason. They offer broad diversification at a low price point – two factors that lead to higher long-term performance. Investors can build a globally diversified portfolio with as few as one fund, or as many as 4-5 funds. They’re easy to buy and sell through a discount brokerage account online, making them a great fit for DIY investors. Check out our ultimate guide to Canada’s discount brokerages to find one that best suits your needs. But here’s a spoiler alert: our top choice is Questrade, where Young & Thrifty readers can get started with $50 in free trades.

Disclaimer: Young & Thrifty has entered into a referral and advertising arrangement with Wealthsimple US, LTD and receives compensation when you open an account or for certain qualifying activity which may include clicking links. You will not be charged a fee for this referral and Wealthsimple and Young and Thrifty are not related entities. It is a requirement to disclose that we earn these fees and also provide you with the latest Wealthsimple ADV brochure so you can learn more about them before opening an account.

Article comments

17 comments
Kumar A says:

1) Can you tell, what are the Canadian Index Funds schemes available from different Fund Houses ?
2) Are these Brokers /Distributors charges are included in MER or separately they charges ?
3) Is there any option to get Index Funds directly from Asset Management Company to get cheaper without commission ?
4) For investing in Index Funds, a Demat Account is mandatory ?

Robb Engen says:

Hi Kumar, every bank has their own suite of index funds (TD, RBC, CIBC, BMO, Scotia). You can also purchase index funds sold by Tangerine bank. In most cases you need to open an account directly at that bank.

The MER will be inclusive of all charges.

I’m not sure what a Demat Account is …

Harry says:

Great article. I have my son’s RESP with TD bank. How can I open “TD Canadian Index e-series” ? Do I need to go to branch or can be accomplished on line .
Thanks

Robb Engen says:

Hi Harry, the best way to purchase TD e-Series funds is to open a TD Direct Investing account and then purchase them on your own. The branch staff are not helpful when it comes to e-Series funds as they are meant to be purchased online only.

Annie says:

Hello, I really love your article. I am 46 year old, I just lost my full time job due to COVID-19 and I am temping at a $22 an hour wage and I work 40 hours a week. I still have an outstanding debt amount of $2200. My question is do you still encourage me to invest $500 every month into Index Funds since I am a beginner?

Robb Engen says:

Hi Annie, so sorry to hear about your job loss. I’d focus on paying off your debts quickly, making sure you have enough cash on hand to survive another temporary job loss, and then worry about investing $500/month. You still have time on your side, but you need to make sure your personal finances are in order.

Ian says:

Best article I’ve read on the subject! I’m a long time passive investor and I’ve noticed lately (Covid-19 crisis) that my US and CAD index funds trend the opposite of the global one whereas in the past all 3 have always trended in the same direction and in the opposite of the bond fund. Any thoughts as to why?

Robb Engen says:

Hi Ian, thanks for the kind words! The pandemic has definitely caused a lot of volatility in the market. Bond funds got clobbered along with stocks. Corporate bonds in particular did poorly as investors flocked to the safety of US Treasuries.

In reality, different markets move in different ways depending on a wide variety of factors. In turbulent times, investors do tend to favour stable economies like Canada and the U.S. The entire experience reinforces the need to diversify your investments broadly across the entire globe.

Abigail Campbell says:

Hi! Loved the article! I am a young investor looking to get started with some index funds but I am starting quite small with only around $1,000 for my first initial investment and plan on investing a set amount monthly. I would like to manage my portfolio myself but am not sure whether to go for index funds at a large bank or with an online discounted brokerage account like questrade. I’ve heard questrade fees can be high for small accounts but I also want to avoid the high fees that come with mainstream banks.

Robb Engen says:

Hi Abigail, thanks very much! You can open a Questrade account with a minimum of $1,000 so you’re covered there. The inactivity fees will not apply to you if you plan on contributing to the account regularly and buying ETFs. So, I’d recommend going with Questrade right away and setting up a regular contribution plan.

Chris says:

I’ve been using Questrade for a few years after RBC Direct and CIBC Investor’s Edge. Questrade is the cheapest by far. It also has the fastest currency exchanges, and most importantly, based on your comment, there is no fee to buy ETFs. (See also: https://youngandthrifty.ca/questrade-review/)
The only minor frustration is funding the account. The initial investment ($1000 min) takes days to process and then a day for each transfer. I do a bill payment from my bank account. It would probably be fairly easy to set up a recurring transfer. I highly recommend it.

Jasim says:

I like this article. One question though: We do not have any Index funds from Vanguard in Canada like the Vanguard 500 Index Admiral Shares (VFIAX)? Our only option is an Index ETF like VFV in this case, if we want to track S&P 500 right? There is still a fee difference (0.04% for VFIAX compared to 0.08% for VFV). Are the dividends automatically re-invested in the ETFs offered in Canada?

Robb Engen says:

Hi Jasim, you’re right that we don’t have access to U.S.-listed index mutual funds like VFIAX. No worries, though. You can invest in an asset allocation ETF like Vanguard’s VEQT (global stocks), or split that up into a portfolio of VCN (Canadian), and XAW (U.S. and International). VFV is also an option if you’d prefer to track the S&P 500.

You can also look at U.S.-listed ETFs, especially in your RRSP, as these will save you MER and foreign withholding taxes) on a larger portfolio.

Dividends aren’t automatically reinvested and instead get deposited into your cash account. You can ask your brokerage to reinvest the dividends, though.

Shawn Ghosal says:

Hi, trying to buy Fidelity zero total market index fund ticker FZROX, not sure how. I use Questrade as broker and buy stocks and ETF through them. Appreciate any help, thanks

Luka says:

Thanks for this fantastic article! I have one question though. If you have a TFSA with a major bank like TD or RBC, can you invest in an external index fund like Vanguard through that TFSA? And since it’s a TFSA, will the index fund gains from Vanguard still be taxed or is it totally tax-free?

Robb Engen says:

Hi Luka, thanks for the kind words. In order to invest in ETFs you need to open a discount brokerage account. So, instead of a TFSA mutual fund account at RBC or TD, you’d want to open a self-directed investing account at their brokerage arm (TD Direct Investing, RBC Direct Investing). From there you can purchase any stock or ETF that’s traded on an exchange. So, yes, that includes Vanguard ETFs like VGRO and VBAL.

Any capital gains, interest, or dividends earned on investments inside your TFSA will be totally tax-free.

skube says:

This is a really great summary of the somewhat confusing topic of funds, index funds and index ETFs. I’m still a little fuzzy on the rationale/criteria behind the construction of the various indexes that drives everything.