Investing 101: Indices and Index Funds

When you hear that “the market is up,” people are often actually referring to an index. An index is a collection of securities or other assets that are meant to represent the performance of an economic sector or portion of the market in reference to a point in time. Indices can be broad or narrow in focus. Some examples of indices and what they represent include:

  • S&P/TSX Composite Index – the Canadian equities market. This index contains stocks of the largest companies on the Toronto Stock Exchange
  • FTSE TMX Canada Universe Bond Index – the Canadian investment grade fixed income market
  • S&P/TSX Capped Energy Index – high-yielding stocks in the Canadian energy sector
  • S&P 500 – the U.S. equities market. This index contains stocks of 500 large companies with common shares listed on the New York Stock Exchange or the NASDAQ Stock Market

These indices give investors a general idea of whether trades within these sectors or markets are experiencing an upward or downward momentum. Many index providers publish a description of how their indices are put together on their websites, so investors can better determine if an index’s focus matches their investment goals.

While people cannot usually invest directly in the indices themselves, they can invest in index funds. Index funds, which are sometimes referred to as index trackers, aim to follow or mimic the performance of a specific index; the value of an index fund will typically go up or down as the index goes up or down. Index funds are generally sold in the form of mutual funds or exchange-traded funds (ETFs).

Tracking the performance of an index is an example of a passive investment strategy. Funds that use passive investment strategies generally have lower costs than funds that use active investment strategies, because the passive fund’s portfolio manager doesn’t have to do as much research or make as many investment decisions. While there can be advantages to active strategies, sometimes passive strategies can outperform active strategies, especially when the costs of the funds are taken into consideration.

However, one potential downside of index funds is that they may have less ability to respond to declines in the value of their investments than a more actively managed fund, because the index fund simply replicates the returns of an index, even if that return is negative.

Active vs passive management

Active strategies usually involve the portfolio manager buying and selling investments to meet a specific return target, or to outperform the return of the overall market or another identified benchmark. Passive strategies generally involve buying a portfolio of securities in order to track the performance of a benchmark or investment model. The holdings of a fund that uses a passive strategy are only adjusted if there is a change in the benchmark or investment model.

Understanding how index funds work

An “index fund” may sound simple enough to understand, but there are some key points investors should be aware of before purchasing an index fund. Most importantly – investors need to know what they’re investing in.

In addition to understanding the index itself, when considering which index fund to purchase, investors should also examine how an index fund replicates the returns of its index. While tracking the returns of an index is a passive strategy, an index fund’s portfolio manager has discretion in deciding how the fund will track the index.

Some funds replicate an index by actually investing in each security that makes up the index, while others try to replicate the index by only buying a sample of securities that possess the same characteristics and features as securities within the index. A third way that funds replicate an index is by using derivatives, such as forward agreements or swaps, which are financial instruments whose price is based on an underlying asset. Each way has its advantages, drawbacks and risks, which should be understood by an investor before purchasing an index fund.

Additionally, some index funds track their index with a multiplier effect, by providing returns equal to two times the returns of the underlying index. Others track their index inversely, so when the index goes up, the index fund’s value goes down, and vice versa. These types of funds tend to make extensive use of derivatives and their returns can be quite volatile. The prospectuses of these types of index funds generally disclose that the funds may not be appropriate for long-term investing.

For all these reasons, it’s important for investors to understand what a fund is tracking, and how it does it. Some index funds are less simple, less diverse and less passive than investors might expect at first glance. This can all factor into whether the fund is appropriate for the investor given his or her investment objectives and constraints.

Investors should always understand what they’re investing in before making a decision. For more information about different investment vehicles and the risks around them, visit GetSmarterAboutMoney.ca.

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