Exchange-Traded Funds (ETFs) are relatively new investment tools that resemble mutual funds in composition, but trade more like stocks. Because they are traded intraday, ETFs can be bought or sold at any time during the trading day. Mutual funds can only be traded once each day and their net asset value must be calculated before any trades can happen. This makes ETFs more liquid than mutual funds while also giving investors more trading options, such as selling short or buying on margin.
Another big difference between mutual funds and ETFs is cost. One of the biggest complaints that investors consistently have about mutual funds is about their high expense ratios. Between administrative and trading costs, the expense ratios of mutual funds are always higher than those charged by ETFs. This is because there are no management fees charged by ETFs because the assets are not monitored by a portfolio manager. Therefore, with lower expense ratios, investors with ETFs can actually invest more of their money rather than see it evaporate into management fees.
Investors use strategies to help them choose the best investment opportunities, whether they are investing in stocks, options, commodities - whatever. There are a number of investment strategies that investors can choose with ETFs, including:
- Sector rotation;
- Portfolio Diversification; and
- Market Timing.
Many of the investment strategies that proved successful when investing in mutual funds also tend to work well with ETFs. Dollar-cost averaging is an investment technique that mutual fund owners tend to like and has proven successful over time. In fact, 401(k) plans are like mutual funds and most employees make small but regular contributions to their fund -- this is really dollar-cost averaging.
The idea behind dollar-cost averaging is that the investor will purchase fewer shares when prices are high but more when prices are low by investing a fixed amount of money at regular intervals. This will eventually drive the average cost per share down to lower and lower levels. Dollar-cost averaging is a time-honored investment technique and it helps prevent investors from investing large amounts of money at the wrong time. Because dollar-cost averaging can involve small investment amounts (as little as $20), the strategy works best when transaction costs are small.
Despite the fact that management fees and other expenses tend to make mutual fund transaction costs pretty steep, investors continue to use the dollar-cost averaging strategy. Since the expense ratios of ETFs are so low, it would only make sense that dollar-cost averaging would work even better with these investment tools -- right?
It is important for investors to understand that the expense ratio does not capture all of the relevant costs associated with an investment transaction -- at least not where mutual funds and ETFs are concerned. Although the expense ratio covers all trading and administration costs for a mutual fund, there are some hidden fees that may
show up from time-to-time, such as:
- Low Balance Fee - This is generally a one-time fee that is assessed annually any time the account balance goes below a pre-determined level.
- Purchase Fee - When you move assets to another fund you may be assessed a purchase or exchange fee. Again, this is not a big amount but it can add up if you are an active trader.
- Redemption Fee - This fee is assessed on any mutual fund owner that does not keep his/her assets in the fund for a predetermined period. In other words, this is an "early-withdrawal" fee.
Many investors new to ETFs hear about the low expense ratios and think they have found the solution to the high fees and expenses assessed by their mutual fund. However, while some investors will indeed benefit from the lower expense ratios on ETFs, other investors may be wiped out by the trading costs. This is especially true for employees who make small, but consistent, investments in their 401(k). The transaction fees assessed by most discount brokers are enough to diminish investment performance on most ETFs to make any standard dollar-cost averaging strategy seem impossible.
When an investor makes a weekly contribution to a mutual fund, the expense ratio remains constant. In other words, whatever management fees and operating expenses amount to in a mutual fund -- the money is taken out in a flat percentage. So for an investor paying fees and expenses of -- say even 4% -- that would amount to only $1 for every $25 invested each week. That means that $24 is actually invested into the mutual fund.
However, the transactions fees charged by brokerages are flat rates -- not flat percentages. Even the discount brokers that simply process orders and charge exceedingly low rates -- like $10 per transaction -- make the dollar-cost averaging strategy impractical for owners of ETFs. A weekly contribution of $25 would shrink to only $15 after
the transaction fee was assessed -- and that doesn't take into account the expense ratio of the ETF. But, even if it were only 1%, that would be a $.25 charge and bring the total investment in the ETF to a whopping $14.75! It doesn't matter how low the expense ratio is on an ETF because the transaction fees diminish investment performance to levels that are unacceptable - at least on small investments.
The dollar-cost averaging theory is not necessarily tied to small investments - just steady ones made at regular intervals. As long as the investor continues purchasing shares with the same dollar amount every time, the dollar-cost averaging strategy should still work and the average cost per share would diminish with time.
But because the transaction costs of ETFs make smaller investments impractical as they diminish investment performance, there are two possible solutions for owners of ETFs wanting to use the dollar-cost averaging strategy: Either make larger investments at shorter regular intervals or save up money and buy shares only once or
twice per year. The dollar-cost averaging strategy is a proven winner and owners of ETFs can still use it effectively if they make larger investments at regular intervals. So long as the investment amounts are the same and the intervals are fixed (be they weekly or annually), the dollar-cost averaging strategy can still work with ETFs.