Canadians, Don’t Overlook Index Funds

03/12/2012 5:45 am EST

Focus: GLOBAL

Rob Carrick

Columnist, The Globe and Mail

If you choose well, you’ll get returns that are quite close to those much trendier exchange traded funds, writes Rob Carrick, reporter and columnist for The Globe and Mail.

Here’s a surprising suggestion for cost-conscious investors who want to make a break from conventional mutual funds.

Try index funds offered by big bank mutual fund families. If you choose well, you’ll get returns that are quite close to those much trendier exchange traded funds. You’ll also benefit from a few index fund attributes that ETFs can’t always match.

Index mutual funds have been around since the mid-1980s, and if you add them all up, they have a not-insubstantial asset base of several billion dollars. But compared to ETFs, index funds are close to moribund as a product category.

With few exceptions, no one ever talks about them. Even the banks that offer them do next to no marketing, a fact you might cynically attribute to the vastly higher sums of money they make selling conventional mutual funds.

A Quick Primer
Both index mutual funds and ETFs offer the returns of stock and bond indexes, minus a fee that usually offers big savings over what conventional funds charge. But there are some major differences between ETFs and index funds.

  1. Cost of ownership: ETFs have lower fees than index funds for the most part.
  2. Access: ETFs trade like a stock, which means you’ll need a brokerage account, discount or full-service, to invest in ETFs. Index funds are sold at no cost in bank branches and through other fund sales channels.
  3. Cost to buy: A few Canadian online brokers—Scotia iTrade, Qtrade and Virtual Brokers—offer no-commission trading of a limited number of ETFs, but otherwise you’ll pay as much as $29 per trade if you’re a do-it-yourself investor. Index funds are bought and sold with no fees (they’re no-load, in other words).
  4. Variety: There are many more ETFs to choose from in both core and fringe categories, while index funds cover portfolio basics.

All six of the big banks offer index funds, with National Bank of Canada offering its lineup under the Altamira name. Additional sellers of index funds are ING Direct, under the Streetwise name; Pro-Financial Asset Management; and Invesco, which has a lineup of mutual funds that invest in its PowerShares family of ETFs.

Fees are by far the top consideration in choosing between index funds. In fact, there’s no better way to drive home the lesson that fees erode returns than looking at index funds.

The cheapest index fund option by far in the Canadian equity category, the e-series version of TD Canadian Index, has a management expense ratio of 0.33% and an average annual return of 7.28% over the ten years to January 31. At the other end of the cost scale is CIBC Canadian Index, which has an MER of 1.12% and a ten-year return of 6.55%. Pay more, get less. That’s how it generally works with index funds.

The ETF that best lines up against these Canadian equity funds is the iShares S&P/TSX Composite Index Fund (XIC), which has an MER of 0.27% and a ten-year return of 7.40%. OK, the ETF choice here beats the index fund competition. But not by much, at least as far as TD Canadian Index e-series goes. In fact, this fund has very slightly outperformed XIC over the three- and five-year periods to January 31.

Results from other Canadian equity index funds reinforce the lesson that as you crank up fees, you diminish returns. The two best performers after TD Canadian Index e-series are offerings from RBC and Altamira, both of which are mid-pack in fees. Bringing up the rear are a selection of higher-cost funds that offer up two lessons to investors.

The first and most obvious is that paying higher fees for index funds makes no sense. And yet, even pricey index investing can be a defensible choice over conventional mutual funds.

BMO Canadian Equity ETF (this is an index fund that holds a BMO ETF instead of actual stocks), with its hefty MER of 1.01%, has outperformed the average Canadian equity fund over all time frames from six months to 20 years, according to Globeinvestor.com data.

In fact, there have only been two cases in the past seven years of an index fund in the Canadian equity category ranking outside the first or second quartile over a calendar year. (Quartiles divide funds in a category into four categories based on returns. First and second quartile rankings are good, third is weak and fourth is bad.)

Altamira Canadian Index ranked in the third quartile in 2010, as did Pro Financial’s Pro FTSE RAFI Canadian Index A. In every other case, bank index funds put their unitholders in the top half of performers in the Canadian equity category.

ETFs are the best vehicle for index investing overall because of their low fees, but index funds do have some useful attributes:

  • Low minimum upfront investments: TD’s index funds have a $100 minimum, while BMO, CIBC, and PowerShares are at $500, and Altamira, RBC, Scotia, and Pro-Financial are at $1,000. You can invest any amount in ETFs, but small sums can be uneconomical if you’re paying commissions of $29.
  • Free rebalancing: With ETFs, brokerage commissions can add up when you adjust your holdings of stock and bond index funds to make sure they correspond to your ideal asset mix.
  • Easy dividend reinvestment: Index funds will automatically reinvest your dividends if you want. It’s possible to set up a dividend reinvestment plan for an ETF through a broker, but this is a second-best solution because you can’t buy fractional shares (as you can with mutual funds).
  • Automatic investment programs are easy to set up: Arrange to have money transferred from your checking account and then immediately invested in a group of index funds.

With all the attention given to ETFs, it’s easy to overlook index funds. But if you avoid the expensive ones, you’ve got a frugal investing option that may fit the novice or tentative investor—even better than ETFs.

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