Investment experts and academics have long debated the merits of index funds vs mutual funds. The difference comes down to two things: methodology and cost. Most mutual funds are actively managed, which means a fund manager makes decisions as to which stocks to buy and sell, and when to buy and sell them. The goal of a mutual fund is to beat a particular benchmark. In contrast, an index fund passively tracks a benchmark (like the S&P 500), without a manager making any active decisions. Active funds charge more than passive funds because they have to pay the manager, researchers, mutual fund dealers, plus an army of fund salespeople. Index funds don’t have that type of overhead and so they charge a fraction of the cost of an actively managed fund.
Canadian investors have nearly $2 trillion invested in mutual funds, most of which are actively managed. But a good portion of these mutual funds charge some of the highest fees in the world. Research from Morningstar clearly shows that absent of a crystal ball, fees are the best predictor of future returns. As in, the lower the fees, the higher the return. Let’s explore the differences between index funds and mutual funds to explain why.
Overview: Index Fund vs Mutual Fund
|Index Funds||Mutual Funds|
|Investment objective||To meet the returns of the benchmark index (e.g. S&P 500, TSX Composite) before fees||To outperform the benchmark index after fees|
|Types of investments||Stocks, bonds (government, corporate), other cash instruments||Stocks, bonds (government, corporate), other cash instruments|
|Management approach||Passive. Asset mix is built to match the exact make-up of the benchmark index||Active. A fund manager determines the securities (stocks/bonds) to buy, hold, and sell|
|Typical management expense ratio (MER)||0.66%||2.28%|
|Annual fee on $100,000||$660||$2,280|
|Growth of $100,000 over 30 years (7% annual rate of return) after fees||$630,484||$398,923|
Do Index Funds Outperform Mutual Funds?
The rise of actively managed mutual funds began in the 1990s when interest rates started to fall, and Canadian investors sought higher returns. Mutual funds enabled all types of investors, large and small, to access markets at a low cost, with no commissions to buy and sell funds. Active managers provide professional portfolio management, diversification, and opportunities for investors to access both foreign and domestic markets.
Active management is often touted as a way for investors to outperform the market thanks to superior investment strategy and insights from the fund manager and research team. Another perceived benefit is the ability of active managers to “avoid” market corrections by making real-time decisions to buy or sell securities and help protect investors’ downside.
In reality, most active managers fail to outperform their benchmark index over the long term. Their ability to avoid market downturns is also overstated. According to the SPIVA Scorecard, more than 88% of Canadian Equity active managers underperformed the S&P/TSX Composite over the 10-year period ending in June 2019.
Simply put: it’s hard to pick winning stocks. It’s hard to time the market. And it’s impossible to identify the best active managers ahead of time – you can only look backwards to see how each manager performed.
Passive investing only become popular in the last 10 years, and Canadian investors still lag behind other countries in the global shift from active to passive strategies. Passive investing makes up just 10% of the market in Canada, whereas nearly half the funds invested in the United States are passively held.
Index funds typically charge a fraction of the cost of their actively managed counterparts. That’s because index funds use a rules-based methodology to passively track their benchmark index. They don’t rely on an active manager to make judgement calls on which stocks and bonds to hold, and when to buy and sell them. With no fund manager or researchers to pay, those savings get passed down to the investor through lower fees.
Best Ways to Invest in Index Funds
These days, passive investors who want to invest in index funds are turning to online brokerages — a low-cost trading platform that lets you buy and sell stocks online. From your computer, tablet, or mobile phone, you can easily design your own asset allocation and portfolio made up of index funds. There are some great online brokerages in Canada, but our top choices are Wealthsimple Trade and Questrade. Both platforms allow investors to purchase ETFs for free, and read our Wealthsimple Trade vs. Questrade breakdown for an in-depth comparison.
Now is a great time to sign up because Wealthsimple Trade is offering Young and Thrifty readers an exclusive deal: get a $25 cash bonus and $0 commission trades when you open a new Wealthsimple Trade account. All you have to do is fund at least $150.
Still learning how to invest? Or consider using a robo advisor — an automated investment service that can build you a personalized portfolio in mere minutes using algorithms. An excellent robo advisor like Wealthsimple can recommend a portfolio comprised of low-cost ETFs and/or index funds. It’s a smart strategy to cut costs and maximize your return on investment. Plus, you can take advantage of our exclusive promo offer: open and fund your first Wealthsimple Invest account (min. $500 initial deposit), and get a $25 cash bonus deposited into your account.
Investors who embrace passive investing through index funds are following the belief (backed by empirical and academic research) that building a low-cost globally diversified portfolio that simply tracks the market leads to the best investor outcomes over the long term.
The theory behind avoiding active management is that high fees and bad individual behaviour lead to poor performance. Instead, buy index funds and investors will achieve market returns, minus a small fee.
Proponents of active management through mutual funds don’t believe in settling for “average” returns. They strive to outperform the index through superior stock picking and market timing skills. It sounds great in theory, but in reality, the vast majority of actively managed mutual funds fail to beat their benchmark index after fees.
The late Jack Bogle, Vanguard founder and father of index investing said:
“What happens in the fund business is that the magic of compounding returns is overwhelmed by the tyranny of compounding costs. It’s a mathematical fact.”
The Deal Breaker is the Cost
It doesn’t take a genius to know that a mutual fund that has to pay managers, researchers, marketers, and salespeople will cost more than a bare-bones index fund that simply represents an index. These costs are passed down to investors through the management expense ratio (MER).
An actively managed mutual fund might charge a 2.25% MER. Here’s how those costs break down:
- Administration charges (overhead): 0.25%
- Fund manager fees (including profit): 1.00%
- Trailing commission (split between advisor and firm): 1.00%
- Total: 2.25%
Investors pay more to own actively managed mutual funds in hopes to outperform the market, yet all evidence shows that high costs all but guarantee an active mutual fund will underperform its benchmark.
Many investors simply misunderstand how much a 2% fee really is. It’s not 2% of 100%. It’s 2% in the same context as earning a 6% return on your investment. Take away 2% in fees and you’re left with just 4% in investment returns. Don’t make the mistake of thinking a couple of percentage points don’t matter – in the long run, they’re huge.
Index funds charge fees, too, but much much less than mutual funds. That’s because index funds typically do nothing more than track broad market benchmarks like the S&P 500. In our example in the chart above, we made two hypothetical investments – one in an index fund and another in an actively managed mutual fund. Both funds earned 7% per year (before fees) for 30 years. The index fund cost 1.62% less than the actively managed fund and its “investor” ended up more than $231,000 richer.
If you’re not comfortable with DIY investing but want to cut costs, take a look at the best robo advisors in Canada. You’ll typically pay less than 1% in fees, but get the benefit of a customized portfolio that suits your goals and risk tolerance. You also won’t have to worry about rebalancing that portfolio once a year — a robo advisor like Wealthsimple will do that for you.
Last Word: Should You Buy Index or Mutual Funds?
Investors should aim to keep their investment costs low and avoid making active judgements on buying, selling, and timing the market. For that reason, index funds trump mutual funds.
New to index funds? Our Beginner’s Guide to Investing in Index Funds will give you all the details about how to get started. If you’re comfortable with DIY investing, index funds are especially easy to buy and sell through an online brokerage. Check out our ultimate guide to Canada’s discount brokerages to find one that best suits your needs, but here’s the short story: our top choice is Questrade, where Young & Thrifty readers can get started with $50 in free trades.
Don’t want to pick your own index funds? Consider a robo advisor like Wealthsimple, which will build you a custom portfolio of index ETFs and automatically monitor and rebalance your portfolio. Now is a great time to sign up because Wealthsimple is offering Young and Thrifty readers an exclusive deal: get a $25 cash bonus open and fund your first Wealthsimple Invest account (min. $500 initial deposit).
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