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.)

Tutorial: Exchange Traded Fund Investing

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 that each fund charges.

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.

When calculating the true cost of a mutual fund, don't forget to examine your account balance and trading habits before assuming that the expense ratio is all that you'll need to pay.

ETF Fees
Calculating the cost of investing in an ETF is a bit easier than calculating the cost of investing in a mutual fund. Instead of delving deep into a dense, poorly worded prospectus written in 10-point font and unearthing charts filled with arcane numbers, ETF investors need only to be concerned about two items: the expense ratio and the commission for the trade.

The expense ratio is a fixed-rate percentage of assets invested, just like the expense ratio of a mutual fund. However, since ETFs trade through a brokerage firm, like stocks, there is also a commission that must be paid for each trade. This commission is the item that investors must be wary of if they plan to dollar-cost-average their ETF contributions.

ETFs: The Costs of Trading
Each time you make an investment into an ETF, you need to consider the costs involved. In doing so, factoring for the expense ratio is the easy part. Since it's a steady percentage of the investment, it has the same impact regardless of the amount of money invested. For example, if the expense ratio is a steady 11 basis points, the cost of the expense ratio is 11 cents on a $100 investment and $1.10 on a $1,000 investment. Because the expense ratio is a percentage, it has no effect on the benefits of dollar-cost averaging.

Trading costs, however, are a different story. Trading costs add up quickly, and, as such, dollar-cost averaging with small dollar amounts is not practical in ETFs - the trading costs detract from the investment's performance. While the expense ratio takes the same bite out of each dollar amount invested, a flat-rate brokerage fee can end up taking a large chunk out of small periodic investments, even at a discount broker that charges a mere $10 per trade. Consider the impact of trading costs on the following investments:

  • On a $25 investment with trading costs of $10, the net investment - after trading costs are subtracted - is $15. The percentage of your investment that disappears as a result of trading expenses is 40%.

  • On a $50 investment with trading costs of $10, the net investment is $40. The percentage of your investment that disappears as a result of trading expenses is 20%.

  • On a $100 investment with trading costs of $10, the net investment is $90. The percentage of your investment that disappears as a result of trading expenses is 10%.

  • On a $1,000 investment with trading costs of $10, the net investment is $990. The percentage of your investment that disappears as a result of trading expenses is 1%.

As you can see, only when you invest more - in bigger lump sums - does the impact of the trading cost go down. But, dollar-cost averaging is all about investing smaller amounts regularly and more frequently instead of larger amounts once in awhile. Clearly, in ETF investing, unless the amounts you are investing regularly are fairly large, the benefits of dollar-cost averaging are overshadowed by the brokerage commission.

The Bottom Line
ETFs can be excellent vehicles for dollar-cost averaging - if the dollar-cost averaging is done properly. As investment amounts increase, the transaction fee remains the same. Rather than investing small amounts of money on a frequent basis, ETF investors can significantly reduce their investment costs if they invest larger amounts less frequently. While dollar-cost averaging with ETFs isn't a strategy that will work well for everyone, that doesn't mean that isn't a valid strategy. Like all investment strategies, investors need to understand what they are buying and the cost of the investment before they hand over their money.

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