Index Funds and ETFs

Portfolios built around ETFs (exchange traded funds) and Index mutual funds are an inexpensive and tax-efficient alternative to actively-managed mutual funds. This is what is known as a form of passive investing. Holding a portfolio that mirrors or mimics the composition of market indices is commonly known as an indexing investment strategy.

Indices such as the S&P 500 in the US and the S&P TSX 60 in Canada are the benchmarks against which many managers of active equity mutual funds measure their performance on a relative basis.

Active managers believe they can outperform their benchmark, earning “alpha” on their investment ideas. Alpha is the excess risk-adjusted return earned over that of the given benchmark or index. According to the Capital Asset Pricing Model, a portfolio that consistently earns alpha has the same beta (systematic risk) as the benchmark, but the manager’s stock selection choices and ability to time the markets contribute to a better return.

Most managers in North America, approximately 75% historically, have not outperformed their benchmark or index. So passive strategies using allocations of index funds and ETFs are a low-maintenance, low-cost alternative for investors. Fees on index funds and ETFs are lower than actively managed funds because they are simply replicating or tracking an index, which requires much less research and lower turnover of portfolio securities than actively-managed funds.

Building a customized portfolio with ETFs and index funds can be a more cost effective way of earning returns equivalent to many actively managed mutual funds. Low MERs (management expense ratios) and greater tax efficiency are the main things that attract investors to using these products in their portfolios. 

Happy investing,

Michael