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I've been hearing a lot about the virtues of index investing. As a small investor, what should I look for in index products?

"If you believe in indexing, you want to own the whole market, not just part of it."

-- Ted Cadsby, author of The Power of Index Funds

Index investments are vehicles that track stock market indices such as the S&P/TSX Index, the Dow Jones industrial average of 30 stocks, or the S&P 500.

When you purchase an index product, you are buying a basket of stocks held in the particular index of choice. In other words, you will own a small piece of the largest companies in Canada or the U.S.

Gaining momentum

Until recently, index investing was an investment choice of institutional investors. Many individual investors were not even aware of index investing, and there were few index products available.

The attraction

Lower fees

The management expense ratios (MERs), those fees that are part and parcel of a mutual fund product, are much cheaper with index investments. For instance, many index funds charge only 0.5% of your assets a year compared with nearly 2.5% for a typical Canadian equity fund.

Because index products mirror the holdings of an index/benchmark, they are known as "passive investments," as opposed to "active investments." Passively managed products are easier to manage. Since there is not so much trading activity, they are cheaper.

Diversification

When you buy an index fund, you are usually gaining a broad mix of companies and industries in one convenient package.

Track record

According to Ted Cadsby, president and CEO of CIBC Securities, and author of The Power of Index Funds, the S&P/TSX Index index outperformed active money managers in 11 out of 17 years. That said, professional managers beat the index for Asian equities, emerging markets and specialist funds.

Choice

You need look no further than your local bank to find a rapidly growing list of index products available. Note: Exchange-traded products (ETFs) such as iUnits and iShares are also available but, although often confused with their mutual funds cousins, actually trade as stocks on the market. Therefore, ETFs incur commission fees from trading.

Convenience.

Instead of trying to pick a stock-market winner yourself, you purchase a investment that contains the top companies in the country. As well, index investments are highly liquid and can be readily sold.

Disadvantages

  • Bumpy road. Remember, an index investment tracks a particular market index. If that index experiences volatility, your investment will do the same.
  • Index Composition. Most equity index funds are heavily weighted in Nortel Corp., and thus have suffered from recent volatility.
  • The long-distance investor. Industry professionals suggest as much as a 10-year time frame to gain the benefits of index investing. Do you have both the patience and time horizon for the long haul?
  • A mixed bag of stocks. Ask yourself - do you really want to hold all the companies in the index product you have chosen?
  • Market Risk. If the market falls, the index will fall. For example, in a slower economy, equity investments don't perform as well.

Wise index investing

Holding a small percentage of index investments in your portfolio offers diversification and reduces risk and volatility. As well, an investor with a longer time frame could benefit from regular purchases through dollar-cost averaging.

Bookmark

Click on www.morningstar.ca, or www.moneysense.ca for information on index products. A good book on the topics is The Power of Index Funds, by Ted Cadsby. Read the prospectus. Know what you're buying!