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ETFs
Does Dollar-Cost Averaging Work With ETFs?
by InvestorGuide Staff (Write for us!)
(Click on the links within the article to get definition of that word)
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 highexpense ratios. Between administrative and trading costs, the expenseratios
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 managementfees.
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, 401k 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 fixedamount of money at regular intervals. This will eventually drive the average
cost pershare 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 transactioncosts 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 ratiocovers all
trading and administration costs for a mutual fund, there are some hidden fees that may
show up from time-to-time, such as:
1. Low BalanceFee - This is generally a one-time fee that is assessed annually any time the account balance goes
below a pre-determined level.
2. 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.
3. 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 401k. 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 flatpercentage. 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 discountbrokers that simply processorders 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.
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