This article provides general educational information about investing in Canada. It is not personalized financial advice or a recommendation to purchase a particular investment.
Index funds and ETFs are often discussed as though they were two completely different investments. That comparison is slightly misleading.
An index fund describes how a fund invests: it attempts to follow a market index. An ETF, or exchange-traded fund, describes how a fund is structured and purchased.
An index fund can be offered as an ETF or as a traditional mutual fund. An ETF can follow an index, but it can also be actively managed.
Understanding this distinction makes it much easier to compare index funds and ETFs in Canada, evaluate their costs and decide which format fits your investment plan.
Key takeaways
- An index is a measurement of a particular market or part of a market.
- An index fund attempts to reproduce the performance of an index.
- An ETF is a pooled investment fund that trades on a stock exchange.
- Many ETFs are index funds, but some ETFs are actively managed.
- Index mutual funds are purchased directly from a bank, fund company or investment platform and are generally priced once per day.
- ETFs require a brokerage account and trade throughout the day.
- Costs include more than the management expense ratio.
- The investment inside the account matters separately from whether you use a TFSA, RRSP, FHSA or non-registered account.
- A broad all-in-one ETF can be a simpler solution than combining several individual funds.
What is a market index?
A market index measures the performance of a selected group of investments.
For example, the S&P/TSX Composite Index represents a broad selection of companies listed on the Toronto Stock Exchange. The S&P 500 measures 500 large US companies. Other indexes follow international stocks, bonds, particular industries or specific investment styles.
You cannot purchase an index directly. It is a measurement rather than an investment product.
A fund company can, however, create a fund that attempts to reproduce an index. That product is called an index fund.
What is an index fund?
An index fund holds investments selected to track a particular market index.
Rather than asking a portfolio manager to choose which companies will outperform, the fund follows a predetermined set of rules. When the index changes, the fund adjusts its holdings accordingly.
This approach is generally called passive investing. Its objective is to capture the market return represented by the index, minus the fund’s fees and other costs.
The Ontario Securities Commission’s investor-education website explains that passive funds generally cost less than active funds because they require fewer research and security-selection decisions. You can read its overview of market indexes and passive investing.
An index fund can use different structures
An index fund might be:
- an exchange-traded fund;
- a traditional mutual fund;
- part of a workplace pension plan;
- part of a managed or robo-advisor portfolio.
“Index fund” therefore describes the investment approach. It does not tell you how the fund is bought or sold.
What is an ETF?
An exchange-traded fund is a pooled investment fund whose units trade on a stock exchange.
Like a mutual fund, an ETF collects money from many investors and uses it to hold a portfolio of investments. Depending on its objective, an ETF might hold:
- Canadian stocks;
- US or international stocks;
- government or corporate bonds;
- short-term fixed-income investments;
- commodities;
- real estate investment trusts;
- a mixture of several asset classes.
The Canadian Investment Regulatory Organization explains that ETFs are pools of investments that trade through a stock exchange in a manner similar to shares. Their risk depends on the investments held inside the fund. More information is available in CIRO’s guide to investment types.
Not every ETF is an index fund
Many of Canada’s largest ETFs follow indexes, but an ETF can also be actively managed.
An active ETF gives a portfolio manager discretion to select or adjust its investments. Other ETFs might follow rules based on dividends, volatility, company size, sectors or investment factors.
The letters “ETF” alone do not tell you whether a fund is diversified, passive, inexpensive or appropriate for your goals.
Why are index funds and ETFs often treated as alternatives?
In everyday Canadian investing, people commonly use “index fund” to mean an index mutual fund and “ETF” to mean an index ETF.
That is why comparisons often describe index funds as products purchased from a bank at the end of the day and ETFs as products traded through a brokerage.
A more accurate comparison is between an index mutual fund and an index ETF.
Index mutual funds versus index ETFs
| Feature | Index mutual fund | Index ETF |
|---|---|---|
| Investment approach | Tracks a market index | Often tracks an index, although active ETFs also exist |
| How it is purchased | Through a bank, fund company or investment platform | Through a brokerage account |
| Pricing | Generally calculated once at the end of the trading day | Changes throughout the trading day |
| Automatic purchases | Often easy to arrange | Available at some brokers and for certain ETFs |
| Minimum purchase | Depends on the provider | Usually one unit, unless fractional purchases are available |
| Trading commission | Usually no separate trading commission | Depends on the broker; many now offer commission-free ETF trades |
| Ongoing fund expenses | Shown through the fund’s MER | Shown through the ETF’s MER |
| Additional trading cost | Generally reflected through the fund’s purchasing process | Bid-ask spread and possible brokerage commissions |
| Advice | May be available through the institution selling the fund | A self-directed brokerage generally does not provide personalized advice |
Neither structure is automatically better. The right choice depends on total costs, convenience, available products and how you want to manage your investments.
Why investors use index funds
Broad diversification
A broad-market index fund can hold dozens, hundreds or even thousands of securities.
This reduces the effect that one company’s failure has on the entire portfolio. It does not eliminate the possibility of losses, but it avoids concentrating everything in a small number of companies.
The amount of diversification depends on the index. A fund tracking the broad global stock market is much more diversified than a fund tracking one industry.
Lower costs
Passive funds often cost less than comparable actively managed funds. Because fees are deducted from investment assets, lower ongoing costs leave more of the fund’s return with investors.
However, “index fund” does not automatically mean “cheap.” Two funds following similar indexes can charge different fees.
Clear investment rules
Index funds normally describe which index they follow and how closely they attempt to reproduce it. This can make the investment approach easier to understand than a strategy that depends on a manager’s changing forecasts.
Less dependence on selecting winners
An index investor does not need to identify which individual company or fund manager will outperform.
The investor still needs to choose an appropriate portfolio and remain invested. The index handles security selection according to its published methodology.
What index investing cannot do
Index funds still carry risk.
A stock index fund can lose significant value during a market decline. A bond index fund can fall when interest rates rise or credit conditions deteriorate. A fund concentrated in one sector or country may be much more volatile than a globally diversified fund.
Index investing also cannot guarantee that you will:
- earn a positive return;
- outperform inflation over every period;
- avoid temporary losses;
- choose the correct level of risk;
- stay invested during a market decline.
The fund may be passive, but the investor still makes active decisions about asset allocation, account type, contributions and behaviour.
Understanding the real cost of a fund
The management expense ratio is important, but it is not the only potential cost.
Management expense ratio
The MER combines the fund’s management fee with certain operating expenses. It is deducted from the fund’s assets rather than charged as a separate bill.
For example, an MER of 0.20% represents approximately $20 annually for every $10,000 invested. The actual dollar amount changes with the value of the investment.
Trading expense ratio
A fund also incurs costs when buying and selling investments. These trading expenses are generally reported separately from the MER.
Brokerage commission
Some brokers charge a commission when an ETF is purchased or sold. Many Canadian brokers now offer commission-free online ETF trades, although other conditions and fees may apply.
Our comparison of the best online brokers in Canada explains the differences between several platforms.
Bid-ask spread
An ETF has a buying price and a selling price. The difference between them is called the bid-ask spread.
This represents a trading cost even when the broker charges no commission. Broad and frequently traded ETFs often have narrow spreads, while specialized or less liquid funds may have wider spreads.
The fund’s ETF Facts document includes information about its MER, holdings, risks, past performance and trading characteristics. The Ontario Securities Commission provides an annotated explanation of the ETF Facts document.
Currency conversion
A Canadian investor purchasing an ETF listed in US dollars may need to convert Canadian dollars into US dollars. Depending on the brokerage, currency-conversion costs can be much larger than the ETF’s annual fee.
A Canadian-listed ETF can still hold foreign investments while trading in Canadian dollars. The trading currency does not, by itself, tell you where the underlying investments are located.
Advice and account fees
Some mutual funds include compensation for advice or distribution in their fees. Brokerage accounts may also charge administration, data, transfer or service fees.
Compare the complete cost of using the fund and account rather than selecting a product solely because it advertises a low MER.
Examples of index ETFs in Canada
The following examples illustrate different market exposures. They are not recommendations.
- XIC follows a broad index of Canadian stocks.
- VCN also provides broad exposure to Canadian companies using a different underlying index.
- VFV follows the S&P 500 through a Canadian-listed ETF.
- XEF follows developed markets outside Canada and the United States.
- ZAG follows a broad Canadian bond index.
- VEQT and XEQT are all-in-one equity portfolios that hold Canadian, US and international stocks.
- VGRO and XGRO combine global stocks with bonds.
Funds that sound similar can use different indexes, asset allocations and portfolio structures. Always read the fund’s current ETF Facts document before investing.
Should you choose one ETF or several?
A portfolio with several ETFs can provide precise control over its Canadian, US, international and bond allocations.
That control creates additional responsibilities:
- selecting each fund;
- deciding the target percentages;
- directing new contributions;
- rebalancing;
- avoiding unnecessary overlap;
- resisting the urge to make frequent changes.
An all-in-one ETF combines several markets in one fund and rebalances internally. For many investors, this is easier to maintain than a collection of individual ETFs.
The best portfolio is not necessarily the one with the smallest theoretical fee. Simplicity can be valuable if it helps you contribute regularly and remain invested.
Which account can hold index funds and ETFs?
The account and investment are separate decisions.
A TFSA, RRSP or FHSA is an account with particular tax rules. The index fund or ETF is the investment held inside that account.
Many mutual funds and securities listed on designated stock exchanges are permitted investments in registered accounts. The Canada Revenue Agency explains the rules for qualified investments in registered plans.
TFSA
Investment growth and eligible withdrawals from a TFSA are generally tax-free. Withdrawals create new contribution room in the following calendar year.
A TFSA can hold cash, mutual funds and securities listed on designated exchanges, among other qualified investments. See the CRA’s explanation of permitted TFSA investments.
RRSP
RRSP contributions may be deductible, while withdrawals are generally included in taxable income. RRSPs are commonly used for retirement savings, but the tax result depends on your contribution and withdrawal circumstances.
FHSA
An FHSA combines a contribution deduction with tax-free qualifying withdrawals for a first home. Its permitted investments generally follow rules similar to TFSAs and RRSPs. The CRA provides additional information about investments permitted in an FHSA.
Non-registered account
Interest, dividends, capital gains and fund distributions can create taxable income in a non-registered account. Record-keeping becomes especially important when calculating the adjusted cost base of an investment.
Choosing between a TFSA and RRSP involves more than deciding which fund to purchase. Our TFSA versus RRSP guide covers the broader account decision.
How to choose an index fund or ETF
1. Start with the purpose of the money
Determine when the money may be needed and what it is intended to accomplish.
Money required for a near-term purchase generally should not be exposed to the same market risk as retirement savings that will remain invested for several decades.
2. Choose an appropriate level of risk
A portfolio containing 100% stocks can experience substantial declines. A portfolio with bonds may fluctuate less, but it also has different expected returns and risks.
Consider both your emotional tolerance for losses and your financial ability to absorb them. Our guide to calculating your investment risk explains why a short questionnaire may not be enough.
3. Decide how much complexity you want
You might use:
- one index mutual fund;
- one all-in-one ETF;
- several individual index ETFs;
- a managed portfolio that uses index funds.
More funds do not automatically create more diversification. Several ETFs can hold many of the same companies.
4. Read the fund document
Before purchasing a fund, examine:
- its investment objective;
- underlying index;
- asset allocation;
- largest holdings;
- geographic exposure;
- MER and trading expenses;
- risk rating;
- distribution policy;
- currency;
- hedging policy;
- historical tracking difference.
5. Consider how the investment fits your routine
Fees matter, but small differences in MER should not be the only consideration. Check whether your brokerage supports recurring purchases, fractional units and automatic dividend reinvestment for the fund you choose.
A simple portfolio that you understand and can contribute to consistently may be more practical than one selected solely because it has the lowest advertised fee.
How to start investing in index funds and ETFs in Canada
Step 1: Build your financial foundation
Before investing long-term money, address immediate cash needs and expensive debt. An emergency fund can reduce the likelihood that you will need to sell investments during a market decline.
Step 2: Select the account
Choose between a TFSA, RRSP, FHSA, RESP or non-registered account according to your goal and tax situation.
Step 3: Choose a service model
Decide whether you want:
- a self-directed brokerage;
- an advisor;
- a managed online portfolio;
- a mutual-fund platform.
A self-directed account offers control, but you are responsible for choosing and managing the investments.
Step 4: Choose the portfolio
Select a diversified portfolio with a risk level appropriate for your goal. Avoid selecting a fund solely because it recently produced strong returns.
Step 5: Create a contribution process
Set a realistic contribution amount and schedule. Automation can reduce the number of decisions required to maintain the plan.
Step 6: Review occasionally
Check whether the portfolio still matches your goal, risk level and time horizon. Constant monitoring and frequent changes are generally unnecessary for a long-term index strategy.
If you are starting from the beginning, our step-by-step guide to investing in Canada explains the complete process.
Common mistakes to avoid
Assuming every ETF is diversified
A fund holding one sector, commodity or narrow theme can be highly concentrated even if it owns several securities.
Read the holdings and investment objective rather than relying on the ETF label.
Choosing according to recent returns
The strongest-performing market from the previous year may not continue to lead. Purchasing after a period of exceptional performance can result in a portfolio driven by recent excitement rather than a long-term plan.
Focusing only on the MER
MER matters, but so do trading commissions, currency conversion, spreads, taxes, advice fees and investor behaviour.
Owning overlapping funds
Holding an S&P 500 ETF, a US total-market ETF, a technology ETF and a global ETF can create substantial overlap. The portfolio may look diversified because it has several ticker symbols while remaining concentrated in the same large companies.
Trading too frequently
The ability to trade an ETF throughout the day does not mean you need to do so.
Frequent trading can create additional costs, taxes and opportunities to react emotionally to short-term market movements.
Ignoring the fund’s risk
A low-cost fund can still be risky. Fees describe cost, while the underlying investments determine most of the risk.
Waiting for the perfect fund
There will always be another product with a slightly different fee, index or allocation.
Once you have selected a broadly diversified, reasonably priced portfolio that fits your risk level, consistent contributions and disciplined behaviour are usually more useful than repeatedly changing funds.
Frequently asked questions
Are ETFs and index funds the same thing?
No. An index fund follows a market index. An ETF is a type of fund that trades on an exchange.
Many ETFs are index funds, but active ETFs also exist. Index funds can also be offered as traditional mutual funds.
Are ETFs better than mutual funds?
Neither structure is universally better.
ETFs often provide low costs and a broad selection, while mutual funds may make automatic contributions and access to advice easier. Compare the specific products, services and total costs.
Can I hold ETFs in a TFSA or RRSP?
Many ETFs listed on designated exchanges qualify for Canadian registered accounts. The account provider may impose additional restrictions, and investors should verify that a particular investment is eligible.
How many ETFs does a beginner need?
A globally diversified all-in-one ETF may be sufficient for some investors. Others may use several ETFs to control their allocation.
The number of funds matters less than the portfolio’s total diversification, costs and suitability.
Do ETFs pay dividends?
Many ETFs make cash distributions from dividends, interest or other income received from their holdings. The amount and schedule depend on the fund.
A distribution is part of the investment’s total return, not free additional money.
Can an index fund lose money?
Yes. An index fund rises and falls with the market it follows, minus costs and tracking differences.
Diversification reduces dependence on individual securities but does not prevent market losses.
Should I invest everything at once or gradually?
The appropriate approach depends on your circumstances and comfort with market fluctuations.
Investing immediately gives the money more time in the market, while gradual purchases may be emotionally easier for some investors. The contribution process should help you follow the plan consistently.
Conclusion
Index funds and ETFs can make investing more diversified, transparent and inexpensive, but the terminology matters.
An index fund describes a strategy designed to follow a market benchmark. An ETF describes a fund that trades on an exchange. Many popular Canadian products are both index funds and ETFs.
Before choosing one, determine your goal, time horizon, account type and appropriate level of risk. Then examine the fund’s holdings, index, costs and trading characteristics.
For many Canadians, a broad index mutual fund or an all-in-one index ETF may provide everything required for a long-term portfolio. The main advantage is not excitement or constant optimization. It is having a clear, diversified strategy that is simple enough to maintain.