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Top Five Reasons to Index Your Portfolio

May 8th, 2007 · 51 Comments

5. Low Costs: It is an indisputable fact: index funds are far cheaper than actively managed mutual funds. The average Canadian equity fund charges a MER of 2.5% compared to fees that are less than 0.50% for comparable index funds. In other words, a fund manager has to beat the index by more than 1.5% just to break even.

4. Low Turnover: Many mutual funds buy and sell stocks frantically in an effort to beat the market. This activity has two costs: brokerage commissions and substantial capital gains taxes. Individual investors also engage in trading: chasing the latest hot stock or fund or sector and incurring hefty fees and taxes (if they are lucky). Even long-term buy-and-hold investors have to constantly decide if they want to hold or sell a stock. Index investors can truly hold their investments “forever”.

3. Relative Returns: Numerous studies have established that mutual funds, as a group, lag the market by roughly their fees. Individual investors, on the other hand, aren’t so lucky. Since they chase the latest hot performer, they end up with far worse returns. One study showed the average investor earned an annualized return of 3.7% in the 20-year period ending in 2004 when the benchmark S&P 500 earned 13.2%. An index investor is never going to beat the markets but won’t significantly lag the markets either.

2. Transparency: You are never entirely sure what you own with many mutual funds. You might hold a Canadian equity fund that has a portion in cash and a portion invested in US equities at the discretion of the manager. Figuring out your actual asset allocation from a motley collection of mutual funds is a time-consuming and frustrating affair. Index funds, by contrast, are a model of simplicity. If you are invested in a fund that tracks the TSX Composite index, 100% of your money is in Canadian equity and you can figure out your asset allocation in a few minutes.

1. Low Effort: If you directly invest in stocks, you need to spend a lot of time reading annual reports, keeping tabs on the competition and checking out analyst reports. If you already have a day job, you are competing with thousands of really smart money managers who pick stocks for a living and have vast resources at their disposal. You’ll also have to agonize about when to buy and when to sell and worry about keeping your emotions in check. Despite all your efforts, you may still be lagging the market, perhaps badly (most investors haven’t a clue how their portfolios are performing relative to the market). With an indexed portfolio, you’ll get whatever returns the market Gods are willing to give, less modest expenses but you’ll have plenty to time to pursue other interests.

This is my submission for ProBlogger’s Group Writing Project. If you are a blogger, I encourage you to get involved. Also check out Canadian Dream’s Top Five Reasons Personal Finance Blogs Are Better Than the Media.

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