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.

This article has 53 comments

  1. Good list!

    One small quibble with #3 Relative Returns. A strategy of bad market timing can be followed just as easily using index funds as it can with regular mutual funds.

    I think it’s more important to have a disciplined investment plan with an asset allocation that you can handle. Once you have that, then using cheaper funds is the no-brainer next step.

  2. CC,

    Thanks for the plug and the great list.

    CD

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  5. Great post. It just about summed up everything I learned from reading piles of books and articles over the past 6 months. Keep up the great work!

  6. Canadian Capitalist

    Mike: Good point. I’ll add the caveat that assuming a proper asset allocation strategy is followed and performance chasing is eschewed.

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  11. I know you could only have 5 reasons, but a sixth would be that Warren Buffett also reiterated at his annual meeting this year that index funds are the best bet for the non-professional investor.

    Poor absolute returns can happen with index funds, though, as there have been stretches of 7 years where the index returns nothing. In this event I think many investors would become there own worst enemy and start switching in and out to their detriment.

  12. Canadian Capitalist

    Leon: Yes, I noticed articles carrying Warren Buffett’s comments and I have bookmarked them for the link round up on Friday.

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  15. Another way of saying what Mike points out re asset allocation is that index funds are the only practical method for most people to actually implement an effective asset allocation strategy and get the benefits of diversification.

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  17. Another important factor is taxes. With a mutual fund you have no control at all over the tax incidence of the trades the fund makes. You can have a down year and still owe taxes because of realized gains. You have much more control with an index fund.

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