Canadian index funds are among the better financial innovations to come along in the past few decades. These are specialized mutual funds that aim to equal the performance of a market index, such as the S&P/TSX 60.

Index funds do show better long-run performance than more than half of actively managed mutual funds with long-term track records. That’s partly because index-fund fees run as low as 0.10% of assets per year, compared to 2.5% or more on many broker-sold funds.

Advantages of Canadian index funds

One big advantage of index funds is that they can help you avoid the risk of choosing a fund with a management style that virtually guarantees below-average long-term performance.

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In our view, mutual funds that pursue a trading or sector-rotation approach belong in this sub-par category. These funds’ managers try to outperform the market by betting on relatively short-term trends. This can work in any one year, say. But in any one decade, the top funds are generally run by conservative managers who focus on long-term growth in the economy. (These are the types of funds we spotlight in “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds .”)

Another advantage of index funds is that they can give investors with limited funds a low-cost way to get some stock-market exposure. They can also be a good starting point for a registered education savings plan, or an in-trust account. Many investors also consider them when they open tax-free savings accounts (TFSAs). (We recently published an update on what to hold in your TFSA. Click here to read that article .)

Canadian index funds can heighten your risk during a market downturn

Despite these advantages, we feel that Canadian index funds are a mistake for investors who wish to make a major commitment to the market. A better strategy would be to build a portfolio of well-established companies, spread out across the five main economic sectors. Or invest in funds that follow this approach, such as the ones we recommend in “Mutual Funds Canada: Inside the Top 10 Canadian Mutual Funds .”

These types of mutual funds tend to lose a lot less than the market indexes when the indexes fall sharply. That’s because big market slides are particularly hard on the hottest, most popular stocks of the preceding rise, and investing as we advise leads you to avoid excessive commitments in these stocks.

Index funds, in contrast, tend to load up on popular stocks as they rise. That’s because, as these stocks move up, they make up a larger proportion of the index.

Today, for example, more than half of S&P/TSX composite index is weighted toward financials, energy and commodities. That’s a higher level of exposure than we feel is appropriate in today’s market, particularly for conservative investors.

However, if you want to invest in index funds, we routinely update subscribers to our Canadian Wealth Advisor newsletter on the best deals available. One example is the iShares Cdn Large Cap 60 Index Fund (Toronto symbol XIU). The fund’s units are made up of stocks that represent the S&P/TSX 60 Index, which consists of the 60 largest, most heavily traded stocks on the exchange. Most of the stocks in the index are high-quality companies. You pay a commission to buy this fund (through a broker), but the fund’s yearly expenses are just 0.17% of assets.