Dollar-cost averaging is a tried-and-true investment master plan 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 gains a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price, and will purchase sundry shares when prices are low and fewer shares when prices are high.
Dollar-cost averaging is a highly popular policy among mutual fund investors because mutual funds, particularly in the context of 401(k) plans, have such low investment minimums that investors can systematically place amounts as small as $25 (or less) without worrying too much about the impact of transaction costs on their interests.
Exchange traded funds (ETFs), which are known for their smaller expense ratios, might seem go for 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 to all intents of a dollar-cost averaging investment strategy and those added costs can overshadow the benefits of DCA.
Key Takeaway
- Dollar-cost averaging is a procedure that involves a series of periodic investments on a regular schedule like weekly, monthly, or quarterly.
- Shares of joint funds and exchange-traded funds are often purchased as part of a DCA strategy.
- Be mindful of fees and commissions when evaluating dissimilar funds for possible dollar-cost averaging strategies.
- The costs of commissions for buying ETF shares can overshadow the benefits of the dollar-cost game when investing relatively small amounts.
Comparing Expense Ratios
When it comes to comparing investment expenditures, many investors scrutinize the mutual fund’s expense ratios. Because ETFs are quite similar to mutual grants, many investors try to compare costs by making a direct comparison of ETF and mutual fund expense ratios.
In such a turn comparison, ETFs typically win, but this is changing. The Vanguard Group—known for low-cost, no-load index funds—now struggles with the low expense ratios of many ETFs. For instance, as of March 2021, the popular SPDR S&P 500 ETF (SPY), at 9.5 footing points (0.0945%) is more than double the 0.04% fee charged by the Vanguard Index 500 Fund (VFIAX).
Importantly, expense relationships aren’t the only fees that fund investors face. To make a more accurate comparison of mutual wealth and ETF costs, investors need to look at the fees charged by each type of fund and any expenses related to buying or convey title shares.
Mutual Fund Fees vs. ETF Fees
The mutual fund expense ratio covers investment management prices, administrative expenses, and 12-b1 fees (which are a type of marketing cost). However, brokerage transaction commissions and sales exhortations (for load funds) are not included in the expense ratio. At the same time, some mutual funds charge a fee if the account rest is below a certain level. This fee is generally less than $25 per year and is imposed if the account balance is underneath a specific dollar figure (say $10,000). As of May 2021, Vanguard’s fee is $20 per year, per account, for account balances below $10,000.
Some stocks also charge a purchase fee on each transaction or an exchange fee if assets are moved to a different fund. Many mutual wealths will also charge a redemption fee if assets are not held in the account for at least a certain period.
When calculating the unwavering cost of a mutual fund, don’t forget to examine your account balance and trading habits before assuming that the expense proportion 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 scheme.
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 intense into a dense mutual fund prospectus, ETF investors can focus on just two items: the expense ratio and the commissions for each ETF achieve within the dollar-cost averaging strategy.
The expense ratio of an ETF is a fixed-rate percentage of assets invested, just like the expense proportion of a mutual fund. However, since ETFs are bought and sold through a brokerage firm, like shares of wares, there is also a commission that must be paid for each purchase or sale of ETF shares.
Some online stockbrokers offer commission-free trading and others might charge a fee per share, but the most common commission structure today is a dead 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 near.
Factoring in the Costs of Trading ETFs
Determining the expense ratio is the easy part when computing the costs of a dollar-cost averaging sound out with ETFs. Since the ratio is a fixed percentage of the investment, it has the same impact regardless of the amount of money inaugurated. 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 proportion 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 extraordinary story. Trading costs from commissions add up quickly and detract from performance. Dollar-cost averaging into ETFs with nugatory dollar amounts is not always practical for that reason.
Stated differently, while the expense ratio takes the anyhow bite out of each dollar amount invested, a flat-rate brokerage fee or commission can take a large chunk out of small repeated investments, even at a discount broker that charges only a flat rate of $10 per trade.
Consider the smashing of trading costs on the following investments:
- On a $25 investment with trading costs of $10, the net investment—after custom 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 return 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 mercantilism 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 swap 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, not when you invest more—in bigger lump sums—does the impact of the trading costs from commissions go down. The objective of dollar-cost averaging, however, is to invest smaller amounts regularly and more frequently instead of larger amounts sometimes in a while. Clearly, in ETF investing, unless the amounts you invest regularly are fairly large, brokerage commissions can overshadow the furthers 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 properly done. Rather than investing small amounts of money frequently, ETF investors can significantly reduce their investment expenses if they invest larger amounts less frequently or invest through brokerages that offer commission-free career.
While dollar-cost averaging with ETFs isn’t a strategy that will work well for everyone, that doesn’t plebeian it isn’t worthwhile. Like all investment strategies, investors need to understand what they are buying and the cost of the investment in advance they hand over their money.