Using index funds as investment strategy

Index funds effectively own the same stocks in the same proportions as a market index. This means an index fund’s performance will always come fairly close to that of the overall market measured by that index. Investing in an index fund is a form of passive investing, i.e. investing with a pre-determined strategy that doesn’t involve any market timing or stock picking.

Index funds gained popularity as they regularly beat almost all actively-managed mutual funds over many years. They’re also well suited for gradual buying within your RRSP. But when markets perform poorly, so will index funds. Still, dividends always pay.

In recent years, many mutual fund firms have offered index funds. Indexing (also known as passive investing) refers to ‘buying the market’.

Index funds replicate a market index—such as the S&P/TSX Composite Index in Canada. Index funds effectively own the same stocks in the same proportions as a market index. This means their performances will always come fairly close to that of the overall market.

Index funds offer you some advantages. The key advantage is better performance. Most actively-managed mutual funds fail to even just match the major market indexes.

Furthermore, while some active funds will beat the indexes in any given year, they are not always the same funds. As a result, the indexes beat almost all active mutual funds.

Indexing beats almost all managed funds

Index funds gain their performance advantage in several ways. First, they don’t hire high-priced money managers to make buying and selling decisions. This cuts the costs of operating an index fund. Second, index funds have low portfolio turnover.

This reduces the costs of trading and keeps unrealized (not-yet-taken) gains working for the fund. Third, index funds hold little or no cash. Given the secular rise in stocks over time, this usually pays. Fourth, major market indexes offer exposure to different industries. That is, index funds hold a well-diversified portfolio of stocks—which produces higher profits.

In the past, however, indexing would’ve occasionally delivered poor results. Say your grandfather had bought an index fund based on the Dow Jones Industrial Average at the market peak in 1929.

This would’ve led to disastrous losses in the years from 1929 to 1932. Even worse, it would’ve taken another 25 years for the Dow Jones to recover to its 1929 high price and for your grandfather to recoup his money.

Under similar circumstances today, indexers would have to wait until the year 2041 simply to get back the money they lost. These numbers reflect what happened in the U.S. But remember, the Canadian stock market only occasionally deviates from the U.S. market—and usually for only a short time.

Up until the mid-1950s it was easier to wait for share prices to recover. Back then, dividends yielded more than bonds. So you could earn high dividend income. Today dividend yields are higher because interest rates are so low. Now many companies prefer to buy back their shares than to raise their dividends.

With dividend yields lower these days, indexers have less income to offset price losses.

Market crashes are not the only setbacks. Consider the period from the end of 1964 to the end of 1981. Over these 17 years, the gross domestic product (the value of all the goods and services produced) of the U.S. rose by 370 per cent. Yet from the end of 1964 to the end of 1981, the Dow Jones Industrial Average wound up unchanged at 875. In other words, indexers would’ve made no gains over this period.

Buy and hold investment strategy wins

Over the years, we’ve found that a buy-and-hold strategy beats active trading. We also regularly advise you to diversify your stock holdings, of course. Apply both ideas and you’ll achieve the benefits of index funds. You’ll also gain other benefits.

Index funds charge fees (albeit low). By owning stocks directly, you can skip these fees. Compounded over the years, such small savings can add up to big money.

You also can take profits in a low-income year to reduce the capital gains taxes you’ll face. Finally, even when the market goes nowhere, some companies’ shares perform well. Even better, if you focus on companies that pay attractive dividends, you can profit even when the market stalls.

In short, index funds have their place. But it’s also important to recognize their limitations.

 

The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846