It’s no secret that with the economy today and rising living costs in Canada, it’s crucial to have more than one revenue stream.
If your primary income source leaves you with enough time, it is possible to look for ways to make money online. But I have always found investing your money to earn passive income is an ideal way for Canadians to add another income source to achieve financial freedom.
Canadian investors have a wealth of financial instruments they can choose to invest in to generate passive income. Index funds are an attractive choice for new investors who want to invest their money in established markets to get the returns they need to meet their goals.
This post will be a guide that lists down some of the best index funds in Canada to help you find the right options. But first, I will take a closer look at what they are and how they compare to other seemingly similar financial instruments to help you make a more well-informed investment decision.
What Is An Index Fund?
An index fund is a financial instrument that you can invest your money in to generate passive income. Many people confuse index funds to be the same as either mutual funds or Exchange-Traded Funds (ETFs).
The truth is, it has qualities of both, and you can consider it a kind of hybrid between mutual funds and ETFs that brings you the best qualities of both asset types.
Index funds are assets that can provide you with exposure to a basket of securities that belong to different segments of the market by mirroring specific indexes.
A single index fund’s constituent securities include all the companies included in a particular market index. When you buy an index fund, you effectively buy a small market slice to mirror its growth.
Take any established market index like the S&P 500. An index fund tracking the S&P 500 Index holds all the 500 constituent securities for the underlying index.
When you buy that index, it spreads your money across the entire index, ensuring that it is well-diversified instead of focused on a narrow basket of individual stocks.
If you prefer a passive investing style with a long investment horizon, index funds give you an easy way to invest your capital and see it grow based on the market movement of popular indexes.
The focus is on replicating the market and not beating it. Since your investment has to mirror the indexes, you don’t need to worry about buying individual securities in a bid to beat the market, making investing a much simpler affair.
Before jumping into the list of the best index funds in Canada, it is important to understand how index funds differ from ETFs and mutual funds. If you don’t know the differences, see below the list for the full breakdown of ETFs vs index funds vs mutual funds.
The Best Index Funds In Canada
Index funds have been a popular investment tool for many Canadians due to the comprehensive but low-cost exposure to different market segments and relatively stress-free approach to investing.
The rise of ETFs in Canada has led to a decline in the popularity of mutual funds and index funds. There are several excellent ETFs in Canada to choose from, but not many index funds to consider.
Some investors might view that as a disadvantage, but I think it is a good thing because it narrows down the options you have to consider. This section of my guide to the best index funds in Canada will list down the mutual funds you can consider buying today.
Some key facts about TD Canadian Index Fund:
- Total Assets Under Management: $2.12 billion
- MER: 0.32%
- Dividend Yield: 2.24%
- Turnover Ratio: 6.10%
TD Canadian Index Fund (TDB900) is an index fund that emulates, to the extent possible, the performance of the Solactive Canada Broad Market Index, net of expenses.
The constituent securities for the underlying market index tracked by TDB900 comprise well-established Canadian companies trading on the TSX. TDB900 is one of the largest index funds available to trade for Canadians.
Some key facts about CIBC Canadian Index Fund:
- Total Assets Under Management: $1.316 billion
- MER: 1.14%
- Dividend Yield: 1.69%
- Turnover Ratio: 12.43%
CIBC Canadian Index Fund (CIB300) is an index fund that emulates, to the extent possible, the performance of the S&P/TSX Composite Index, net of expenses. The S&P/TSX Composite Index is the primary benchmark index for the Canadian stock market.
The constituent securities for the underlying market index tracked by CIB300 mostly comprise well-established Canadian companies in the financial sector, and it focuses on some crucial industrial sectors.
Some key facts about RBC Canadian Index Fund:
- Total Assets Under Management: $1.164 billion
- MER: 0.66%
- Dividend Yield: 2.11%
- Turnover Ratio: 7.77%
RBC Canadian Index Fund (RBF556) is an index fund that emulates, to the extent possible, the S&P/TSX Capped Composite Total Return Index, net of expenses.
The constituent securities for the S&P/TSX Capped Composite Total Return Index primarily comprise equity securities of Canadian companies across various sectors of the economy.
Some of the top investments for the fund include the Royal Bank of Canada, Canadian National Railways, and the Toronto-Dominion Bank.
Some key facts about Scotia Canadian Index Fund:
- Total Assets Under Management: $373.38 million
- MER: 0.77%
- Dividend Yield: 1.74%
- Turnover Ratio: 6.30%
Scotia Canadian Index Fund (BNS1814) is an index fund that emulates, to the extent possible, the S&P/TSX Composite Index net of expenses. The constituent securities for the S&P/TSX Composite Index include all the companies trading on the Canadian stock market.
When you invest in BNS181, you are essentially diversifying your investment capital allocated to the fund into the entire Canadian stock market. The underlying index primarily invests in the financial industry, including the Toronto-Dominion Bank and the Royal Bank of Canada.
Index funds have several qualities that make them an attractive asset to consider if you are a first-time investor who doesn’t have a lot of time on your hands and are cautious about investing your money. Of course, not every financial instrument is perfect for every aspiring investor.
Index funds offer plenty of benefits, but they come with their drawbacks. This section of my guide to the best index funds in Canada will discuss the pros and cons of index funds to give you the information you need to make a better decision on whether index funds are a suitable investment for you.
- Low Cost: While index funds carry a higher fee than ETFs, these funds offer you significant savings compared to mutual fund products. Without fund managers actively rebalancing the fund’s holdings, you do not have to contend with high management fees.
With low to zero trading commissions, an investment portfolio comprising of index funds will typically cost you between 0.05-0.25% per year. Actively managed mutual funds can cost you 1-2% per year.
- Diversification: New investors who do not have a good understanding of how to diversify their portfolios can get a helping hand if they invest in an index fund.
If you are not looking to get market-beating returns and are happy with tracking the growth of a particular market that has been doing well, investing in a corresponding index fund will automatically diversify your funds into those companies across various industries.
- Accessibility: Some mutual fund products require doing a lot of research and paying high management fees to expensive fund managers or financial advisors. With index funds, you can invest in a market that you are interested in without having to worry about which stocks will perform the best.
Index funds let you take on a passive approach to investing by simply mirroring the market instead of trying to beat it. You don’t need to bother with paying a financial advisor to help you make investment decisions or pay high management fees to fund managers.
- Limited Flexibility: Some investors might appreciate the qualities of index funds that make them ideal long-term investments. But if you are an investor who wants to have more control over what companies you hold in your portfolio, these funds do not give you the flexibility you might prefer.
Similarly, if the index holds companies that you do not like due to their business practices not aligning with your moral values, you cannot do anything about it and have to bear with the investments that the index fund holds regardless of how you feel about it.
- Low Returns: Another quality that makes index funds a good option for many investors is that this asset type typically offers lower capital risk than picking and choosing individual stocks for your investment portfolio to beat the market. This is particularly true if you are an investor with a long investment horizon because buying and holding market indexes for the long haul can help you ride out dips and bear markets. However, as with any investment, the low capital risk comes with low rewards.
Most of the companies held within an index are likely well-established firms that offer consistent and steady but modest growth. You might find it challenging to invest in market segments that you recently developed an interest in because most market indexes focus on well-established companies.
If you find a new high-growth opportunity that you want to dabble in to achieve significant wealth growth through rapid capital gains, it will likely be impossible to find an index fund that holds the asset.
- Lack Of Quick Liquidity: Index funds are ideal as part of a long-term investment strategy. The best way to maximize your return on investment in index funds is to invest in a fund that follows a market of your preference and forget about it for years to enjoy the returns as the market index grows.
Unfortunately, if the market index does not offer wealth growth at rates that you prefer or cannot keep up with inflation rates, you might not meet your financial goals. Additionally, short-term market downturns can impact your returns and leave you in a difficult position if you are expecting short-term returns.
While index funds bear similarities with ETFs and mutual funds, it’s important to understand that the three are not the same financial products.
Index Funds vs. ETFs
ETFs are similar to index funds because they aim to track specific segments of the market and typically are passively managed. Being a passively managed fund means that ETFs are a low-cost financial instrument because they do not have a fund manager actively rebalancing the portfolio to try to beat the market.
However, ETFs come with more of an affordable price tag that any novice investor with a small initial investment capital can purchase on the stock market. Index funds are similar to mutual funds in that they require a prerequisite of high minimum investments.
You will need to set aside significant money as investment capital to purchase an index fund.
Index funds do not trade on the stock market like ETFs. You can buy and sell ETFs throughout the day on the stock market, but you can only make one trade a day with index funds after the market closes because that is when their price is set.
It means that index funds offer lower flexibility than ETFs when it comes to making quick trades.
ETFs are not limited to tracking market indexes. ETFs also make it easier for you to gain exposure to a decent mixture of different asset types like bonds and stocks. You can buy ETFs that track more diverse market segments, and there are even ETFs that track the performance of commodities like gold and silver.
ETFs are also famous for being accessible due to their lower overall cost. They come with lower investment fees than mutual funds because they are passively managed funds.
Combine that with little to no investment premiums, and you get a financial instrument that is more affordable than index funds. The lowest-cost exposure to baskets of securities has lately made ETFs increasingly popular among Canadian investors than any mutual fund or index fund product.
Technically speaking, index funds are essentially a type of mutual fund. However, that is where the similarity ends between the two asset classes. Mutual funds are actively managed funds with fund managers responsible for actively realigning the portfolio’s constituent holdings to try and outperform the broader market.
Mutual fund managers regularly rebalance the funds’ holdings by buying and selling assets and reinvesting in different industries and asset types that they believe will give investors greater growth than the broader market.
As an investor who holds a mutual fund product, you might constantly find yourself worrying about whether the fund managers can deliver on the promise of providing you with market-beating returns.
Index funds take a simpler approach to utilize the pooled resources. The fund managers do not try to rebalance the fund’s constituent holdings to try and beat the market based on the assets or industries that they think can offer market-beating growth.
Instead, they simply compose the fund with all the constituent securities in a particular market index and holds them based on their representation within the index.
Since index funds take a passive investment approach, they have significantly lower annual management fees than mutual funds.
How To Buy Index Funds in Canada
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Finding and investing in the best index funds in Canada can provide your portfolio with considerable returns if you are a new investor with a medium to low-risk tolerance, have the investment capital, prefer a passive investing style, and plan to buy and hold the assets in your portfolio for the long run.
There are certain drawbacks of investing in index funds that might not make them a suitable investment for you to consider for your portfolio based on your financial goals.
Suppose that you are interested in creating a portfolio of low-cost financial instruments that can provide you with a decent monthly income. In that case, choosing dividend ETFs might be more suitable for you than putting your money in an index fund.
You should check out my list of the best monthly dividend ETFs in Canada if you want to earn regular passive income.