Calculating the Break-Even Point of ETFs Over Mutual Funds

by Kevin on April 28, 2013

In my previous post I asked if using a dollar cost averaging investing method ruined the appeal of ETFs. If you are trying to build out a diverse portfolio — that is, more than 1 or 2 mutual funds — then I do think ETFs have limited use simply due to trading costs.

A brief side note: one reader pointed out there are some brokerage firms offering commission-free ETF trades. This is the ideal, but you have to be aware of what exactly are in those ETFs. I’m making my calculations as if I am the average investor that only knows the big names and mainstream ETFs. However, if you find those brokerage commission-free ETFs are good values with the same expense ratios, then switching to those can save you significant cash in the long run.

However, that isn’t to say you can’t use ETFs in your portfolio or your Roth IRA. You just have to be smart in how you get there.

Calculating When Lower Expenses of ETFs Beat Mutual Fund Expenses

I wanted to see how long it would take — if ever — to break-even using ETFs instead of mutual funds.

I set up a spreadsheet with the following inputs:

  • $5,500 annual contribution to a Roth IRA
  • 7% annual growth
  • Trades cost $7 each
  • 0.0845% ETF portfolio expenses
  • 0.18% mutual fund portfolio expenses

The only variable: how many trades per year on the ETF side. I then ran calculations to show growth of the portfolio over 30 years (which impacts how much in expenses are paid each year) as well as the cost of the trades (which only applied to the ETF portfolio since my mutual fund contributions are free).

I then totaled the total expenses paid on the mutual fund side as well as the combined expenses plus trade commissions paid on the ETF side. Then you simply compare the two. This gave me the same mutual fund total expense cost of $10,051.76 over the life of the investment. (You end up with $519,534 in the portfolio, so not bad.)

Here are the results.

Trading 3 Times Per Month with ETFs vs. Investing in Target Date Retirement Mutual Fund

If you were trying to perfectly replicate the portfolio of Vanguard’s Target Date Retirement 2050 fund you would need three ETFs: a total stock market ETF, a total international market ETF, and a total bond market ETF.

You would then invest in each fund every month using as close to the same percentages to the Target Date Fund (63.2% total stock market, 26.8% total international market, and 10% total bond market). That would mean 3 trades every single month as part of your dollar cost averaging.

If you pursued this strategy, these are your results:

  • Mutual fund costs over 30 years: $10,051.76:
  • ETF costs including trading commissions over 30 years: $12,278.74
  • Difference for ETFs: ($2,226.98)

You end up a few thousand dollars behind using this strategy. Despite the lower expense ratio of the ETFs, the trade costs eat up the difference. You do eventually get ahead but it takes until year 36 before you break-even on the ETFs.

Trading 2 Times Per Month with ETFs vs. Investing in Target Date Retirement Mutual Fund

If you change things up so you only trade 24 times per year, perhaps doing monthly contributions to the stock ETF and then combining a couple of months of international or bond trades into one trade, you start to eek out an edge:

  • Mutual fund costs over 30 years: $10,051.76:
  • ETF costs including trading commissions over 30 years: $9,758.74
  • Difference for ETFs: $293.02
But just barely.

Trading 1 Times Per Month with ETFs vs. Investing in Target Date Retirement Mutual Fund

Of course if you could figure out how to just trade once per month you come out well ahead over the long term to the tune of $2,813.02.

  • Mutual fund costs over 30 years: $10,051.76:
  • ETF costs including trading commissions over 30 years: $7,238.74
  • Difference for ETFs: $2,813.02

How to Use ETFs in Your Roth IRA Portfolio

It might be difficult to keep track of just having 12 trades per year but still remaining diversified across 3 different funds. If so there is still one more way you can use ETFs inside a Roth IRA. I’ll tackle that in my next post.

{ 1 comment… read it below or add one }

Sun April 29, 2013 at 10:56 pm

My question would be how much automation do you receive with mutual funds vs ETFs? Is the difference in potential savings worth bothering about over 30 years? My targeted retirement mutual fund with Vanguard is purchased automatically every two weeks for me. ETFs I have to purchase myself. Over 30 years, that is 780 trades… Even if I trade once a month, the $93 difference would not be enough to beat the automation.

Even if you have to pay for trade, you can pay less at TradeKing or OptionsHouse. For commission free, you can see a list here… http://etfdb.com/type/commission-free/all/

If you’re going to trade ETFs inside a Roth, look at Betterment as an alternative. Or even look at LendingClub with a $10k minimum to p2p lend inside an IRA.

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