Does Dollar Cost Averaging Ruin the Appeal of ETFs?

by Kevin on April 21, 2013

In my previous post I told you about contemplating switching from mutual funds with Vanguard to exchange traded funds (or ETFs) with equivalent index ties.

In the portfolio I crafted as an example, I showed that the switch would drop my expense ratios down from 0.18% to 0.0845%. This savings of 0.0955% on every dollar invested would be achieved by swapping out my shares in Vanguard’s Target Retirement 2050 fund for the following mix of ETFs:

  • 63.2% Vanguard Total Stock Market ETF (0.05% expenses)
  • 26.8% Vanguard Total International Stock ETF (0.16% expenses)
  • 10.0% Vanguard Total Bond Market ETF (0.10%)

However, this isn’t just a cut and dry issue thanks to how you acquire shares in mutual funds and ETFs. This in turn impacts the appeal if you are using dollar cost averaging as your method of acquiring new shares.

The Difference in Acquiring Mutual Fund and ETF Shares

You don’t invest in mutual funds the same way you do ETFs. (Or, if you are, you’re doing it wrong.)

How to Invest in Mutual Funds

There are two different methods of investing in mutual funds:

  • through a broker that charges a trade fee
  • directly with the mutual fund company, usually without a fee

(I’ll let you guess which method I prefer.)

Instead of paying a trade fee every time I invest, I prefer to go directly to the fund company to set up my Roth IRA. My fund company of choice is Vanguard, but T. Rowe Price, Fidelity, and others can be good options. I like Vanguard because of their low investment cost mentality.

When you invest in mutual funds directly with the fund company you shouldn’t pay a trade fee for the privilege to do so. That means 100% of the money you send the company goes directly into the mutual fund investment you select. (Of course you pay the expense ratio annually, but you would do that no matter how you acquired the shares.)

How to Invest in ETFs

Despite their incredibly low costs, ETFs are unfortunately acquired only through trading with a broker. That means that every single time you want to invest you have to pay your broker’s ETF trade fee.

Granted this fee can be as low as $4 or $7 depending on the company you select, but if you are trying to build a portfolio of several ETFs each month this can turn into quite the expensive proposition.

Increased ETF Costs with Dollar Cost Averaging

If you only traded once per year to buy all of your shares then exchange traded funds would absolutely be a steal. You would pay one single brokerage charge and get to enjoy the low expense ratio. It would be an all around win.

But if you are like me and want to have automatic investments come out of your account every month to build your portfolio then those pesky trade fees add up.

Here’s a brief breakdown of the fees you would pay in a 12 month period assuming $7 trade commissions paid to your broker:

  • 1 ETF (like Vanguard’s Total Stock Market ETF): $84
  • 2 ETFs (add Vanguard’s Total Bond Market ETF): $168
  • 3 ETFs (add Vanguard’s Total International Market ETF): $252

These fees represent a problem for us. Remember how much switching to ETFs would save us?

A savings of 0.0955% in annual expense ratios would equal:

  • $47.76 per year with a $50,000 portfolio
  • $95.52 per year with a $100,000 portfolio
  • $477.60 per year with a $500,000 portfolio
  • $955.20 per year with a $1 million portfolio

If you end up paying $252 in trade commissions in a year, you are wiping out all of your expense ratio gains up to a portfolio size of $263,874.35. Above that number and you start squeaking ahead even with paying all of the commissions.

However, that is looking at things from a total portfolio perspective. There is one problem with this: you aren’t investing $263,873.35 each year (or at least I’m not!). That is just what you would need to break even the next year if you paid $252 in total trade commissions this year.

If you are like me, you’re just trying to fill up your Roth IRA to the IRS allowed maximum each year. If you are filling up a Roth IRA with $5,500 this year, paying $252 in trade commissions is foolish when you could have paid $0 in trade commissions and just a fraction more in expense ratios by investing directly in mutual funds.

But does this mean the idea of using ETFs in your Roth IRA is dead? Not quite. I’ll cover that in my next post.

{ 2 comments }

Sun April 21, 2013 at 5:43 pm

You can use schwab etf they don’t charge a fee for single share purchases.

AWB April 24, 2013 at 12:01 pm

Brokerage firms might have heard your complaint as they now offer commission free ETFs. These can be dollar-cost-averaged without commission. The only catch seems to be there are a limited number of these ETFs so if the ones you’ve researched and liked aren’t on the list there’s still a commission.

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