Index fund

An index fund^[1] is a mutual fund that seeks to replicate the movements of an index of a specific financial market such as the S&P/TSX Composite Index, the S&P 500 or the Canada Universe Bond Index^{[note 1]} This is accomplished by:

Holding all of the stocks, bonds or other securities in the index, in the same proportions as the index, or
Holding an optimized subset of the securities in the index, maintaining a very high correlation between the index itself and the subset.

Since the composition of an index fund is a known quantity, they generally have lower management expense ratios (MERs) than actively managed mutual funds^[3]. Another alternative is an exchange-traded fund (ETF), which may have lower costs but also has other key differences.

Asset class style consistency

Once an investor has crafted an investment policy statement and decided upon an asset allocation, the investor then implements the plan by selecting appropriate funds for the planned allocation. Index funds make suitable building blocks for asset allocation purposes because they can be trusted to remain reliably close to their declared style parameters.

The tendency for funds to shift their center of style gravity is termed "style drift", the divergence of a mutual fund from its stated investment style or objective.^[4] For example, an active large cap fund manager may invest in mid cap and small cap stocks, or add international stocks to the portfolio, or have the valuation style of the portfolio drift from value to growth. Such style drift takes the asset allocation control of the portfolio away from the investor and places it into the unpredictable hands of the fund manager. Another common example of style drift occurs when an active small cap fund grows exceptionally large. The fund usually must buy larger stocks, and will commonly see its center of style gravitate towards a mid cap style.

Comparison of index mutual funds and index ETFs

Index mutual funds and index ETFs have some key differences that an investor should be aware of when making a choice.

The old rule-of-thumb was that index mutual funds were more suitable for small, frequent purchases (for example in systematic investment plans), whereas index ETFs were cheaper for one-time major purchases. Now that some brokers offer commission-free ETF trading, and that some brokers are charging clients to buy or sell mutual funds, the rule-of-thum no longer generally applies.

Using both

If the investor has a brokerage account, it is possible to use index funds and ETFs simultaneously. See Index funds versus exchange-traded funds for discussion.

How to choose index mutual funds

Choose your detailed asset allocation before you look at specific investment vehicles.
If buying index funds in a mutual funds account, make sure that the chosen provider offers all the funds you need. Some mutual fund companies only have a few index funds, others have a more comprehensive coverage of asset classes.
In a brokerage account, funds from different providers can be mixed if desired.
Avoid loads: numerous no-load funds are available.
Look at the underlying index. Is it the most common one in this category? If not, does the index used by the fund under investigation correlate strongly, and have the same annualized returns, as the most common index?
All else being equal, the lower the MER, the better, but also check the tracking error.
Does the fund use currency hedging? This may or may not be a desirable feature.

Financial Wisdom Forum member Bylo Selhi has a list of no-load low-cost index mutual funds^[3] that is slightly outdated but provides an excellent starting point for investigation. A list of recommended index funds and ETFs is maintained by Canadian Couch Potato. You can also use the globefund filter, selecting "Load Type: No Load"; "Management Expense Ratio: <= 1.00%"; "Fund Type: Open-Ended"; "Index Funds: Yes". Most of the list consists of ETFs, but the index mutual funds are in there too; click on "key facts" to obtain the MER.

Impact of dividends on NAV (net asset value)

What happens to the dividends paid to the mutual fund by companies whose shares the index fund holds? Those dividends form part of the income of the index fund, and increase the fund's net asset value (NAV). They are usually aggregated, the fund is paid its MER, and the remainder is then paid out to holders of the index fund in the form of dividends.

Impact of distributions on NAV

Distributions from index funds can consist of multiple components, dividends, interest income, capital gains, return of capital and other income.

What happens to the distributions paid out by the index fund to its unit holders? The NAV of the fund decreases by the amount of distributions paid out. Some unit-holders choose to DRIP, i.e. use the distributions to buy more units. The extra number of units just cancels out the drop in NAV, and the unit holder is left as before, except for some accounting.

Notes

^ FTSE TMX Global Debt Capital Markets (formerly PC-Bond / DEX) is the predominant provider of fixed income indices in Canada, best known for the Universe Bond Index.^[2]

References

^ Wikipedia, Index fund, viewed Feb. 21, 2009.
^ FTSE TMX Canada Indices, viewed January 13, 2015.
^ ^a ^b "Bylo Selhi", Low-MER, No-Load Index Funds Available in Canada, viewed Feb. 21, 2009.
^ Style Drift Definition | Investopedia, viewed January 13, 2015.

External links

Model Portfolios | Canadian Couch Potato
Indexing, Bogleheads wiki

[3] FTSE TMX Global Debt Capital Markets (formerly PC-Bond / DEX) is the predominant provider of fixed income indices in Canada, best known for the Universe Bond Index.^[2]

[1] Wikipedia, Index fund, viewed Feb. 21, 2009.

[2] FTSE TMX Canada Indices, viewed January 13, 2015.

[bylo-4] "Bylo Selhi", Low-MER, No-Load Index Funds Available in Canada, viewed Feb. 21, 2009.

[5] Style Drift Definition | Investopedia, viewed January 13, 2015.

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