Freedom Life Planning

The Ultimate Guide to Financial Planning

Index Investing

In this article I will explore my favorite way to invest, which is index investing. Index investing is a passive investing strategy that does not try to beat the market, but instead the goal is to match the returns of the markets while minimizing fees. There are three major advantages of index investing, diversification, low management fees (MER) and little effort from the investor. Index investing is an easy approach to investing that requires little research and has been shown to produce results, on average, matching or beating actively managed funds.

Most people have 9-5 careers and are not professional stock traders. In order to properly invest in stocks, it requires a lot of research on the company you are looking to invest in. Also as most people are investing their life savings to reach their goals, they must diversify in many stocks to minimize their risk. In today’s world, most people will benefit by investing globally in stock markets around the world. Converting currencies, transaction fees and the need for extensive stock research make this approach difficult for someone who is not a career stock trader or has a net worth below 1 million dollars.

Therefore, the mutual fund came along simplifying this by pooling everyone’s money together and actively managing the stocks being held. Mutual fund managers charge an MER for this service of around 1-3%. While a fee of 1-3% doesn’t sound like a lot, in reality, it is a huge chunk of your potential gains.

This is because it is applied annually on your total holdings, not just your gains or losses. For example, I will take an average period of 20 years, where the stock market returns 9% per year, while inflation is estimated at 3%. This results in a return of 6% after inflation. Now if the MER of the fund is 2%, that represents 33% of your after-inflation gains (2% of an average 6% return). This will have a huge impact on your future savings when planning for long term goals, especially retirement.

A company’s stock price, especially large cap companies, is driven by market forces that are analyzed by professional traders and large managed funds. The stock price is already adjusted for the expectations on the future performance with publicly available knowledge. Therefore, for an active mutual fund manager to beat the index, the manager must outperform all these market forces that are already intensely studying the stock price. In addition, the fund manager must outperform the market forces by 33% after inflation to account for this high management fee, year after year! From the research that I’ve seen, this is often not the case and the index fund will beat most funds out there. I’m not saying that it is impossible to find a managed fund out there that will beat the index fund for a given period. What I will say is that it is highly unlikely that the selected actively managed fund will consistently beat the index. The safe bet is on the index fund.

Below are the end of 2016 results of the RBC US Equity funds. I’ve highlighted the RBC mutual fund that tracks to the S&P 500 index. Now when looking at this result, keep in mind, it is still a mutual fund and has a relatively high MER of 0.72%, but still lower than the other actively managed funds. Looking at the 5 year returns, it has the best results. For the 10 year returns, the second best results. This is certainly above the average actively managed fund.

However, the MER can be reduced even further by investing in Exchange Traded Funds (ETF) that track the same index. ETFs from Vanguard or Blackrock (iShares) have MER’s often around 0.1%. A low MER like this will only represent less than 2% of the 6% after inflation stock market gain per year (compared with 33% of the active mutual fund). The graph below shows the impact of a high MER on a $10,000 investment over 40 years. The Blue line is the market index, set at an average return of 9%. The grey line is the ETF tracking the index with an MER of 0.1%. The orange line is the mutual fund with a 9% annual return and a MER of 2%.

After 40 years, here are the results of the growth of a $10,000 Investment (no inflation):

Market Index = $314,094

ETF = $302,772 (Lost Potential Earnings = -$11,323)

Mutual Fund = $149,745 (Lost Potential Earnings = -$164,350)

After 40 years, the different between the Index ETF and the actively managed Mutual fund is huge. The difference is not only due to the MERs directly paid to the fund management, but also the lost potential of not reinvesting this amount into the fund. The low-cost Index ETF has a value of more than double the mutual fund. Beyond 40 years, the difference will keep compounding!

Today there are many ETFs available on the market that provide easy access to markets indices around the world for very low fees. There are also ETFs that track bond indices allowing for an equity and bond split for more short term goals. It is especially important for bond funds to keep the MER as low as possible since they return even smaller (but more consistent) gains.

However, there are still some situations where a mutual fund is preferred over an ETF. An ETF will charge per transaction fees (usually around 10$) to buy and sell the ETF. Most mutual funds will not charge a buy or sell fee, but make up for it with the higher MER. The first situation where the index mutual fund is superior is for investments below $2,000. The 10$ fee is significant in this case and you’re better off holding the mutual fund. The second situation would be for regular contributions added. If you add $200 per month to your investments, you will pay 120$ by the end of the year in fees buying ETFs. That would represent transaction fees of 5% of the total value invested. For these cases only, mutual funds are the better choice. At the end of the year you can then convert in one transaction all your accumulated mutual fund contributions to an ETF to minimize the transaction fee and the MER.

So it’s time to stop paying high management fees to these mutual funds and start index investing to keep your gains inside your portfolio. With more and more ETF’s appearing on the market, index investing will continue to grow in the future. It’s time for you to get started.

For more information in index investing, check out this great book on index investing.

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