Fortune Teller

The Dangers of Dollar-Cost Averaging Small Amounts with ETFs

Fortune Teller

Exchange-traded funds have low annual fees and tax distributions, but brokerage transaction fees can remove all the benefits for unwary small investors. Dollar cost averaging in small amounts, a great strategy with traditional mutual funds, is a particularly questionable practice with ETFs, and alternatives should be considered.

Dollar-cost averaging is the practice of adding fixed amounts to an account on a regular schedule to enforce the discipline of saving. Normally there is no fee to add small amounts directly to a traditional no-load mutual fund, whereas there is a charge for buying any ETF, which must be bought and sold like a stock through a brokerage house. For substantial purchases, this transaction fee is an insignificant percentage, but for small purchases it becomes unreasonable.

To illustrate this, consider how the traditional Vanguard 500 index mutual fund (AMEX:VFINX) stacks up against the SPDR 500 (AMEX:SPY), an ETF, in a typical dollar cost averaging scenario. Both funds track the S&P 500 index. The Vanguard 500 fund has an expense ratio of 0.18%, while SPDR 500 checks in at 0.11%.

The analysis assumes:

  • a $10,000 initial investment to both funds
  • $100 monthly contributions to both funds for the next 10 years
  • 7% annual returns for both funds (reasonable since they track the same index)
  • $10 commissions for each ETF trade (reasonable with discount broker)

The results show the low annual fee of the ETF is not enough to overcome the transaction fee drag:

Fund name Expense ratio (%) Total costs ($) Final value ($) Annualized return (%)
Vanguard 500 0.18 389.70 36,258.20 6.81
SPDR 500 0.11 1,450.54 34,729.11 6.23

Source: Morningstar Cost Analyzer

After ten years the final value of the Vanguard 500 investor's account would have been $1,529.09 more than the SPDR 500 investor. The Vanguard 500 also returned over half a percent more per year after costs, a significant amount over long time periods. The results illustrate the dangers of dollar-cost averaging ETFs with small amounts.

In contrast, ETFs show strength when sums are invested in larger amounts, because the flat transaction fee becomes an increasingly small percentage of the amount invested and the lower fees of ETFs becoming the driving force in the comparison. Coupled with tax advantages, exchange-traded funds make more sense for investors who invest a large lump sum or whose regular deposits are above $1,000.

"Generally speaking, if you're investing a significant lump sum for a sufficiently long period of time then you're going to be better off with an ETF," said Morningstar analyst Christopher Traulsen.

Otherwise, the investor has the option of traditional mutual funds, of making less frequent deposits to their account or of keeping cash in a money market account in the interim. The latter strategy lowers the investor's exposure to equities and thus to both the likely return and possible risk they entail.

The buy-and-hold simulation shown above assumes selling all ETF shares at the end of the time period. Investors who buy or sell shares more frequently naturally pay more in trading commissions. There are many variations of the simulation that could be run to reflect an individual investor's situation. For investors who slice-and-dice the market with several ETFs, the commissions generated from contributing to multiple funds each month can really drain portfolio returns.

Traulsen noted that the simulation does not take into account the low account balance fees charged by some index fund providers - it does factor in fund expenses and loads. Although this isn't an issue because the simulation above assumed a $10,000 initial investment, Vanguard index funds for example deduct a $10 annual fee if a non-retirement account balance falls below $2,500. The simulation also does not reflect the transaction fees that investors may pay if they invest in mutual funds through brokerage firms.

For most popular broad indexes, investors have a choice of ETF or index fund. The best option depends on how much they have to invest, how they choose to invest that money over time, and the commissions charged by their broker.