The allure of index investing

“Index investors will never beat the index,” an investment authority firmly told me 20 years ago. “Ergo, there is no point in indexing.”

Back then, pre-dotcom meltdown, pre-financial crisis, pre-housing bust and pre-recession, the whole point of investing was to beat the market. In this case, “the market” was a particular index.

Since then, investors have discovered that it’s incredibly tricky to assemble and manage a winning stock portfolio.

It’s equally difficult to create a portfolio of mutual funds, among the thousands available, that do beat their comparable indices over time. Fees are the main culprits. GetSmarterAboutMoney’s mutual fund fee calculator is a nifty tool that lays bare the impact of fees on return.

Enter indexing (also called passive investing) as an effective way to invest in both fixed income and equities. There’s no race to outperform “the market”. Investors simply pick products, called exchange traded funds (ETFs), which mimic an index. Best of all, the management fees are a fraction of those charged by mutual funds.

From two ETFs available 20 years ago, there are now 340 of them offered by nine ETF providers with management fees as low as 0.05% annually compared to between 1.75% and 2.25% for many mutual funds.

There are also a host of index mutual funds competing with ETFs. These products follow the same investing strategy by simply mimicking a given index. Fees are higher than with ETFs, around 1% is typical, but far lower than actively managed mutual funds.

Many have been nervous about investing directly in ETFs because, unlike mutual funds, ETFs are listed on a stock exchange. Trading fees once made regular investing, or dollar cost averaging, prohibitively expensive. Nowadays, competition has driven down fees from $30 per trade to as little as $5, depending on the size of one’s portfolio and / or the amount of business (mortgages, lines of credit, etc.) with a given bank.

Even better, some banks have recently made limited offers of low fee trading for everyone, not just existing customers.

Once upon a time, few advisors recommended ETFs because they didn’t receive any sales commission; instead, mutual fund companies paid advisors to sell their funds.

But the world is changing rapidly. Increasingly, advisors are opting to be paid directly by clients who want index portfolios. Also, some ETF providers are now offering advisor class products with a commission structure, but the overall fees are still lower than with mutual funds.

An even more recent change is the appearance of so-called robo-advisory services. You select a portfolio of ETFs and the service invests according to a desired schedule, while rebalancing portfolios automatically to maintain an asset allocation.

Robo-advisors don’t ask about your kids, but you do get a simple, low-fee service.

Research shows that indexing usually produces higher returns over time than a portfolio of mutual funds or stocks. But the strategy isn’t without risk. The key to success is investing in a limited number of products and sticking to a conservative asset allocation.

One ETF tracking a large Canadian index (e.g. the S&P\TSX 60) and one mimicking a major U.S. index (e.g. the S&P 500) and one for bonds is a great core portfolio. Tweak the percentages according to your situation and stomach for risk. You don’t need to get fancy to have a portfolio that will serve you well over time.

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