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Dollar-cost averaging is a tried and true investment strategy that enables investors to participate in the financial markets in a cost-effective way without the need to make large, lump-sum investments. It is a particularly popular strategy among mutual fund investors, as mutual funds (particularly in the context of 401(k) plans) have such low investment minimums that investors can systematically deposit amounts as small as $25 (or less) without worrying about their investment returns being diminished by transaction costs. Exchange-traded funds (ETFs), with their often-minuscule expense ratios, would seem to be the perfect vehicles for dollar-cost averaging, but initial appearances can be deceiving.
(For more on the relationship between expense ratios and dollar-cost averaging, see Dollar-Cost Averaging Pays.)
Expense Ratios: ETFs vs Mutual Funds
When it comes to comparing investment costs, mutual fund expense ratios figure prominently, and are often cited by the media. Because ETFs are quite similar to mutual funds, to compare the costs between the two, many investors often make a direct comparison of ETF and mutual fund expense ratios. In such a direct comparison, ETFs almost always win by a landslide. Even the Vanguard Group - known for their low-cost, no-load index funds - can't compete. State Street's SPDR 500 ETF, at 11 basis points, trounces the 18 basis-point fee charged by the Vanguard Index 500 fund.
Although expense ratios take center stage, they aren't the only fee that fund investors have to face. To make a more accurate comparison of mutual fund and ETF costs, investors need to look at the fees each charge.
Mutual Fund Fees
The mutual fund expense ratio covers investment management fees, administrative expenses and 12b-1 fees (certain marketing costs). However, brokerage transaction commissions and sales charges (for load funds) are not included in the expense ratio, and many funds charge a low-balance fee. This nuisance fee is generally less than $25 per year and is imposed if the account balance is below a certain dollar figure (say $10,000). Some funds also charge a purchase fee on each transaction and/or an exchange fee if assets are moved to a different fund. Many funds charge a redemption fee if assets are not held in the account for at least a certain period.
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