During the 1999 calendar year, a great deal of press was devoted to Index Funds. They are essentially a passive portfolio of investments that mirror the index from which they are derived. A TSE 300 Index fund for example, would hold the 300 different stocks that compose the TSE 300 index. Because the portfolio is passively managed, the management expenses (MER's) are lower on Index Funds compared with other actively managed equity funds.

In 2000, the hot topic in the press was Exchange Traded Funds (ETFs.)  With the decline in the major indices in 2001, however, investor interest in both has waned.  Sadly, but as usual, investors piled into these funds at close to their highs, and then have sold as indexes fell much more than the average mutual fund.  We continue to feel that indexing a portion (up to 20%) of your portfolio can make sense because of the fee savings over the very long term, however there are also risks to consider.

Interestingly, in 2004, 5 years after the boom in index fund investing, the average canadian actively managed fund has outperformed the index. For more on this, see the article "Most Funds Outperform Index over Last 5 Years" by ScotiaMcLeod Director, Carl Spiess.

We are pleased to report that your ScotiaMcLeod account offers you in excess of 30 different Index Funds, and dozens of ETFs from which to choose, including many recognizable names. Index Funds from the Scotia Funds family do offer the benefit of low $500 minimum purchase amounts or $50 in PAC plans, and as always, with the benefit of no loads. You can view a complete listing of index funds available through ScotiaMcLeod, and their performance --> here.

A word of caution: Index Funds which are 100% RRSP eligible foreign funds should not be held outside an RRSP account as increases in value are taxed as income rather than capital gains.

Also, be careful of the risk of index funds, which are much more volatile than a typical managed equity portfolio. (But less risky than sector specific funds.)

See an article by our good friend Duff Young about the risks of index funds, and a similar article by ScotiaMcLeod's own Ian Filderman (.pdf 144k) and another link to a commentary on index funds from the financial pipeline site.

We see both the pros (low MERs, and little ongoing monitoring required) of index investing and the cons (higher risk, tax implications, and performance divergence).  In the end, even with index funds, it is appropriate to diversify.

In general, index funds should have higher after tax returns than normal actively managed funds, as they don't trade their portfolios.  However, since many of your fellow index fund unitholders may be market timers and not buy and hold investors, some index funds can actually have very high distributions, 2000 was a particularly bad year.  As reported in the Toronto Star, one investor in the Royal US premium index fund had a taxable gain distributed of $89,000, resulting in his Old Age Security payments clawed back because his net income topped $55,000 for 2000.

Another way to get index fund like returns, but with potentially less risk, is to look at style diversification. Synergy Asset Management (now part of CI Mutual Funds) offers a group of style funds. Their Canadian Style Management Class, has produced higher than index like returns, with lower risk.  It is a fund with lower risk in the time period shown below.

Source: Synergy Asset Management
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