Dollar-Cost Averaging With ETFs

Dollar-cost averaging is a tried-and-true investment strategy that allows investors to participate in the financial markets in a cost-effective way without the need to make large, lump-sum investments. When dollar-cost averaging, an investor buys a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price, and will purchase more shares when prices are low and fewer shares when prices are high.

Dollar-cost averaging is a highly popular strategy among mutual fund investors because 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 too much about the impact of transaction costs on their returns.

Exchange traded funds (ETFs), which are known for their smaller expense ratios, might seem like perfect vehicles for dollar-cost averaging, but initial appearances can be deceiving. In fact, transaction costs can quickly add up when you use an ETF as part of a dollar-cost averaging investment strategy and those added costs can overshadow the benefits of DCA.

Comparing Expense Ratios

When it comes to comparing investment costs, many investors scrutinize the mutual fund’s expense ratios. Because ETFs are quite similar to mutual funds, many investors try to compare costs by making a direct comparison of ETF and mutual fund expense ratios.

In such a direct comparison, ETFs typically win, but this is changing. The Vanguard Group—known for low-cost, no-load index funds—now competes with the low expense ratios of many ETFs. For instance, the popular SPDR S&P 500 ETF (SPY), at 9 basis points (0.09%) is more than double the 0.04% fee charged by the Vanguard Index 500 Fund (VFIAX).

Importantly, expense ratios aren’t the only fees that fund investors face. To make a more accurate comparison of mutual fund and ETF costs, investors need to look at the fees charged by each type of fund and any expenses related to buying or selling shares.

Mutual Fund Fees vs. ETF Fees

The mutual fund expense ratio covers investment management fees, administrative expenses, and 12-b1 fees (which are a type of marketing cost). However, brokerage transaction commissions and sales charges (for load funds) are not included in the expense ratio. At the same time, some mutual funds charge a fee if the account balance is below a certain level. This fee is generally less than $25 per year and is imposed if the account balance is below a specific dollar figure (say $10,000).

Some funds also charge a purchase fee on each transaction or an exchange fee if assets are moved to a different fund. Many mutual funds will also 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. There are a number of other fees to consider, and the details are typically outlined in the mutual fund prospectus.

By way of comparison, 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 mutual fund prospectus, ETF investors can focus on just two items: the expense ratio and the commissions for each ETF purchase within the dollar-cost averaging strategy.

The expense ratio of an ETF is a fixed-rate percentage of assets invested, just like the expense ratio of a mutual fund. However, since ETFs are bought and sold through a brokerage firm, like shares of stock, there is also a commission that must be paid for each purchase or sale of ETF shares.

Some online brokers offer commission-free trading and others might charge a fee per share, but the most common commission structure today is a flat fee per trade. In short, commissions are the key item that investors want to consider when adding exchange-traded funds to a dollar-cost averaging approach.

Factoring in the Costs of Trading ETFs

Determining the expense ratio is the easy part when computing the costs of a dollar-cost averaging approach with ETFs. Since the ratio is a fixed percentage of the investment, it has the same impact regardless of the amount of money invested. For example, if the expense ratio is nine basis points, the cost of the expense ratio is nine cents on a $100 investment and 90 cents on a $1,000 investment. The expense ratio is fixed and so it doesn’t matter if the investment is large or small because the percentage remains the same.

Commissions, however, are a different story. Trading costs from commissions add up quickly and detract from performance. Dollar-cost averaging into ETFs with small dollar amounts is not always practical for that reason.

Stated differently, while the expense ratio takes the same bite out of each dollar amount invested, a flat-rate brokerage fee or commission can take a large chunk out of small periodic investments, even at a discount broker that charges only a flat rate of $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 costs from commissions go down. The goal of dollar-cost averaging, however, is to invest smaller amounts regularly and more frequently instead of larger amounts once in a while. Clearly, in ETF investing, unless the amounts you invest regularly are fairly large, brokerage commissions can overshadow the benefits gained from dollar-cost averaging.

The Bottom Line

ETFs can be excellent vehicles for dollar-cost averaging—as long as the dollar-cost averaging is appropriately done. Rather than investing small amounts of money frequently, ETF investors can significantly reduce their investment costs if they invest larger amounts less frequently or invest through brokerages that offer commission-free trading.

While dollar-cost averaging with ETFs isn’t a strategy that will work well for everyone, that doesn’t mean it isn’t worthwhile. Like all investment strategies, investors need to understand what they are buying and the cost of the investment before they hand over their money.