Index funds, explained without the jargon

If you have ever asked a financially savvy friend where to start investing, there's a good chance they said "index funds." Here is what that means in plain words, and why it's such common advice.

What an index is

An index is simply a list of companies chosen by a set rule. For example, one well-known index tracks about 500 of the largest companies listed in the United States. Others track the biggest companies in Canada, the whole world or just bonds.

An index fund buys everything on that list, in roughly the same proportions. When the index goes up, the fund goes up. When it falls, the fund falls. It doesn't try to beat the market. It tries to be the market.

Why "average" can be a good thing

Many professional fund managers try to pick winners, and they charge for the effort. Over long periods, studies have repeatedly found that most of them fail to beat a simple index after their fees are taken out. Index funds skip the picking, so they can charge much less.

Fees look small, but they compound. A difference of one percentage point a year can add up to a large share of your savings over a few decades.

What to look at before you buy

• What it tracks. A fund of large Canadian companies behaves very differently from a global fund or a bond fund.
• The fee. Look for the management expense ratio (MER) or expense ratio. Lower is generally better for similar funds.
• How you'll hold it. Many index funds trade like stocks, as exchange-traded funds (ETFs). Others are mutual funds bought through a bank or advisor.
• The account it lives in. Tax-sheltered accounts such as a TFSA or RRSP in Canada, or a 401(k) or IRA in the U.S., can make a big difference to what you keep.

The part nobody likes to hear

Index funds still fall when markets fall, sometimes by a third or more in a bad year. They work best for money you won't need for many years, held through the ups and downs. Their biggest advantage is that they make investing dull, and dull is often what keeps people from making expensive emotional mistakes.

If you aren't sure which fund or mix fits your goals, a fee-only financial planner, paid by you rather than through commissions, can help you decide.