What is Index Investing?
Index investing is really quite a simple, safe and financially rewarding way to own stocks. Here is the best part, anyone can do it.
Index investing refers to the strategy of buying an entire stock market index and holding your desired portfolio allocation. An example of an index is the well known S&P 500, which simply is a basket of the 500 biggest companies in the United States. Buying a S&P 500 index fund means that you can own all 500 companies and your return is the average of the performance of all 500 companies.
Lets take another example, the S&P/TSX 60 index. This is another "index", or basket, of the 60 largest companies traded on the Toronto Stock Exchange. Holding a S&P/TSX 60 index would give you the average performance of all 60 of those large capitalization companies.
Why Should I Invest in an Index?
Although I also hold individual companies that I have found to be undervalued to their intrinsic value, I hold a few different indexes (baskets of companies) for a variety of reasons:
Index investing outperforms 80% of mutual fund managers annually
It is a great way to grab international exposure without trading in foreign currency
Cheapest way to own a large number of companies and provides diversification
If you wish to own bonds - a bond index is a fantastic way to do that
You will receive a dividend income
Before you begin - Understanding ETFs
An ETF, or Exchange Traded Fund, is a basket of stocks and usually tracks an index like the ones we have discussed above. An ETF allows you to buy the basket of stocks that it tracks exactly like you would buy an individual stock. For example, if you buy "Vanguard US Total Stock Market", ticker VUN, you will acquire a sliver of every stock traded in the United States. Meaning you will be officially an owner of companies like Apple, Exxon, Amazon, Google, Microsoft, etc. the list goes on for thousands of companies. The prefix "Vanguard" simply means a company called Vanguard owns all of those stocks and will let you buy a piece of the fund for a very small annual management expense ratio (MER) of generally around 0.15%. That fee is rock bottom low compared to the fees on actively managed mutual funds.
Step 1: Open a Self-Directed Brokerage Account
If you have not done so already, open a self directed brokerage account. I have ranked my personal favourite brokerages account in this blog post. If you wish to only dabble in indexes I suggest a brokerage that allows free ETF trading such as Questrade.
Step 2: Choose a Risk Tolerance
You need to select a tolerance to market fluctuations that you are comfortable with. A general rule of thumb is to select your age as a percentage of bonds in your portfolio and the rest as stocks. I personally don't think anyone with a long investment horizon of beyond 10 years needs any bonds in their portfolio. Stocks will outperform bonds over time.
Step 3: Select your Indexes
Every year, ETF providers are undercutting each other's Management Expense Ratio (MER). Generally, you just want to select the lowest MER that is offered for the index being provided. Here is a sample portfolio of index ETFs.
VCN - All Canada Index
This Vanguard fund has a MER of 0.05% and will provide broad exposure to all market capitalizations in Canada.
XUU - US Total Stock Market Index
This iShares fund has a MER of 0.07% and will provide the entire US Stock Market traded in Canadian dollars. Pretty hard to go wrong here.
XEF - International Developed Countries Index
This iShares fund has a MER of 0.2% and will provide companies internationally from Japan, Europe, Australia and more.
VEE - Emerging Markets Index
This Vanguard fund will provide exposure to Chinese and other emerging markets at a MER of 0.23%.
ZAG - Canadian Aggregate Bond Index
This fund from BMO will hold long and short term bonds with corporate and government exposure all for a rock bottom MER of 0.09%.
Side note - Taxable Accounts
The best fund to use in taxable accounts is the ETF, HXT. This Horizons fund tracks the S&P/TSX 60 and does not distribute dividends, but rather the distributions are absorbed in the Net Asset Value (NAV). Not to mention, the MER is 0.03%! By far the best option as a tax efficient fund that tracks Canada's best known index at an incredibly low MER.