Learn about the benefits of indexing
15 November 2017 | Indexing
Indexing is a passive approach to investing. Managers of indexed investments seek to track the performance of an index, which represents a broad market or a portion of it. A growing percentage of investments in Canada, including most exchange-traded funds, fall into this category.
Index investing—through ETFs or mutual funds—can offer several significant benefits, including diversification, low costs, competitive performance, the potential for tax efficiency, and simplicity.
Maintaining a diversified portfolio is an essential part of a successful investment plan, and indexing can be an ideal way to achieve diversification. It’s difficult for actively managed funds to compete with index funds when it comes to diversification relative to a market segment. That’s because index funds generally hold most or all of the securities in their target indexes.
Index funds have a powerful advantage over actively managed funds—lower costs. Here are two main reasons:
- Lower management expense ratios. It simply costs less to manage and operate an index fund. That’s because index funds don’t have to employ highly paid teams to analyze and select stocks.
- Lower transaction costs. Index funds use a buy-and-hold approach, which means that index fund managers generally trade securities less often than active fund managers do. Less trading reduces the brokerage commission and other expenses associated with trading securities.
Thanks to their diversification and low costs, index funds can be an effective way to achieve competitive returns over the long run.
Potential for tax efficiency
Because index funds typically make trades less frequently than actively managed funds, they tend to realize and distribute less in capital gains. This is particularly beneficial within taxable accounts.
There's nothing complicated about how index funds are designed. They have a precise, easily understood objective: to track the performance of a specific index (before fees and expenses). With index funds, you always know how your money is invested.