What is an index fund?

Given the name of our blog, I figured it’s a good idea to do a basic definition of what an index fund is.

Before I define it however, a bit of background. Investing has a variety of things called asset classes. These are ‘types’ of investments and cover such things as stocks, gold, money market funds (GIC’s and the like), real estate, even art.

Index funds are normally associated with stocks. Over time the popularity of stock index funds has grown wildly in the public consciousness and so other asset classes. So now you can find index fund looking investments in money markets, bonds, even real estate.

What is a stock?

A stock is representation of partial ownership in a company, and is often comingled with the term ‘share’. Lets say you own a company. Part of the incorporation process is setting up a number of shares, and determining who owns those shares.

As companies grow, eventually they want to raise money for growth purposes, and want to sell some of their company ownership or shares. If the company qualifies, they can sell their shares to the public through a stock exchange. This means the company has ‘gone public’. Generally when discussing index funds, we are referencing shares only of publicly traded companies shares.

Initial theory behind index funds

So, you’re going to invest in ‘stocks’ or shares, i.e. the ‘stock market’. Lets start with you buying shares from a single company.

Now, there’s two generally accepted factors used to evaluate such a share; the risk (often called the Beta), and the reward – the potential rate of return. The risk refers to the potential for not getting the return. You can think of it as the volatility – the return jumping up and down, maybe higher, but also maybe way lower.

So you choose a company with an expected rate of return of 15% because, hey, 15%. But that comes with a wild risk that maybe you earn -15% instead of +15%. We want to mitigate the risk, stop the wild possible swings in return.

So, what to do? We’re going to buy a second stock in something nice and stable, maybe a bank. For the bank stock maybe we expect 6%, but that return is fairly certain.

Now our overall investment is partly going to earn 15% with high volatility, and 6% with low volatility. Our total investment now earns say 10% with acceptable volatility.

Now lets optimize this process. We’re going to continue to add stocks with the intention of keeping our investment returns high, while lowering the possible volatility or swings from year to year.

Mathematically, it’s been shown that the blend of company shares that achieves the highest rate of return, at the lowest risk (over long periods of time) is ‘all companies’.

And that’s what an index fund is – it’s an investment where you’ve selected all companies on a stock market. Note that changing the balance of all companies (maybe you get rid of one or two) will result in likely having lower rates of return, or higher risk of not achieving your target rates of return. So mathematically, ‘all companies on the stock exchange’ is an index fund.

So mathematically, an index fund should be your best buy for investing in stocks. But there are other reasons why it’s a good investment. Since you’re not trading stocks, you’re not paying to trade stocks (obviously). Which keeps expenses on index funds low, and that contributes to higher returns. Fees on index funds are generally amongst the lowest available for any type of long term investment.

Variations on index funds

Investment firms have created variations on index funds. Some have large cap index funds, which would be all companies, but only of a certain size. Others have created industry specific index funds, maybe all tech firms, or all oil and gas firms. While not technically index funds, they’re often billed as such.

Investment firms have also created index funds that attempt to invest in companies internationally – i.e. US. or Europe, or Asia. If you’re getting into these, more research is required because changing these variables can be better, and they can be worse.

And as I mentioned earlier, investment companies have also created index funds in other asset classes, i.e. you can get a bond index which is an investment in a wide variety of bonds.

Index funds in Canada

It is possible to invest in a ‘raw’ index fund. Most of the Canadian banks have one available, you can set them up inside your RRSP or TFSA. Perhaps the most popular and oldest is the TD Bank TSX index fund, which covers all stocks on the Toronto Stock Exchange, but other banks have similiar offerings.

Index funds are also often combined with other asset classes inside a mutual fund, so you might have a mutual fund with 90% index fund, and 10% cash (some liquid cash is required to maintain the index fund).

Summary

So there you have it. An index fund is an investment with ‘all’ companies on a stock exchange. The intention is to get the highest possible rate of return, at the lowest risk possible, over a long period of time. They’re available at most investment companies and banks, and are often available inside mutual funds and inside RRSP’s and TFSA’s.