Why Index Funds Are So Popular When Investing For Retirement

 

Why Index Funds Are So Popular When Investing For Retirement

An index fund is often a type of investment fund with a portfolio constructed to provide the price appreciation of a financial market index. An example of this would be the Standard & Poor's TSX/60 Index (S&P/TSX 60) which tracks the top 60 companies on the Toronto Stock Exchange. They are unlike traditional, actively managed mutual funds where portfolio managers and their teams analyze, evaluate and acquire individual stocks.

In recent times, particularly when investing for retirement, more and more people have decided to choose index funds over picking individual stocks. According to Professor Eugene F. Fama, Nobel Prize in Economic Sciences, 2013, 97% of brokers do not beat the index net of fees. Index funds have gained popularity through endorsements from legendary investors such as Warren Buffett (Berkshire Hathaway) and Jack Bogle (Vanguard), and their consistent returns over longer periods speak for themselves.

 

Low Fees

Index funds are passive investments that hold a broad basket of stocks which are not actively traded. This is unlike actively managed funds which are often actively traded and deduct commissions incurred trading the stocks. This may also trigger tax liabilities for the fund. Along with paying commissions on a large number of trades and triggering tax liabilities, actively managed funds have to pay the salaries of a team of analysts, portfolio managers and administration staff. This is why they have to charge high annual administration and management fees, often around 1.5% of holdings, regardless of how they perform. The commissions, taxes and annual administration and management fees eat into the fund’s returns considerably and greatly affect the power of compounding.

Index funds on the other hand are not managed and seldom trade (only periodic trades to rebalance the fund as changes are made to the underlying index composition). Index funds are therefore able to charge drastically lower fees which can often be a fraction of those of an actively managed fund. 

 

Strong Returns

An index fund’s returns are directly correlated to the performance of the underlying index and, over longer periods of time, such as ten years, leading indices almost always produce positive returns*.  

Let’s take the S&P/TSX 60, for example.  This index has an average historical return of 6.72% annually*, over ten-year periods. Like all stock market investments, this return is not a straight line and sees fluctuations from year to year. However, even though the economy may falter from time to time, the average annual return of a leading index fund, over longer periods, has performed well.

 

Rebalancing

Investing in stocks can be complicated at times. When rebalancing stocks in your portfolio, it probably requires a visit to your financial advisor, so you can review your options and create a new plan. This may require buying or selling multiple stocks or bonds, so you can achieve your desired level of risk. It may also cost more money and fees to switch around your investments.

However with an index fund you don’t need to worry about any of that. Index funds are automatically rebalanced for you. For ease of reference, let’s look at the S&P/TSX 60 once more. This fund tracks the top 60 companies on the Toronto Stock Exchange at any given time. If one of those companies is not performing well, it will be removed from the index, and the next top company will be moved into its position. You can always be sure that you are holding a well-balanced portfolio when investing in an index fund.

 

Diversification

Diversification is key to any investment portfolio. Your risk is greatly reduced when your investments are diversified across different sectors. Diversification is used to produce stable returns by investing in different areas that would each react differently to the same event. Effective diversification requires a large portfolio and often expensive professional advice to set up and manage on an ongoing basis. Index funds are perfect if you are looking for a non-complicated investment that is spread across a number of different stocks and sectors. Index funds are already diversified for you, so you do not need to manually adjust them.

For reference, the S&P/TSX 60 is well diversified by holding stocks of businesses across 10 different industry sectors. This includes financial services, energy, communication services, consumer staples and utilities, just to name a few. With this diverse mix of companies in your portfolio, your risk will be reduced greatly.

 

Easy to Maintain

Index funds are known for their ease of management, as they are a passive investment. Holding an index fund doesn’t require you to check on it regularly or to have to make regular investment decisions. A person can invest in an index fund at any age and reinvest in index funds until retirement. In fact, looking at that long-term buy and hold approach, in the past twenty-five years the S&P/TSX 60 has increased by over 293%.**   

Overall, index funds can be a great asset to any investor as part of their portfolio, and they usually have very low minimums so are very accessible for most investors. It makes investing simple, low stress and low in fees.

We hope that our breakdown of index funds was helpful to you and that it gave you a clear picture of how they can be of great value to your portfolio.

 

If you have any questions about the S&P/TSX 60 or index funds in general, please feel free to contact Brain Moylett, at 778-951-2806 or bmoylett@wisdomsi.ca. He is a part of our Retire on Time team, and always available to answer questions.

* Calculated point-to-point from January 28, 1982 through to June 30, 2019 over 10-year periods. Only 9 ten-year periods out of 6,871 were negative.

** Takes April 27, 1995 price of $225.01, and takes April 27, 2020 value of $884.53 which is an increase of 293.11%

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