Dollar-Cost Averaging With ETFs

Dollar-cost averaging allows investors to participate in the financial markets cost-effectively without the need to make large, lump-sum investments. An investor buys a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. They'll purchase more shares when prices are low and fewer shares when prices are high.

Dollar-cost averaging (DCA) is a highly popular strategy among mutual fund investors because mutual funds have such low investment minimums, particularly in the context of 401(k) plans. Investors can systematically deposit amounts as small as $25 or less without worrying too much about the impact of transaction costs on their returns.

Exchange-traded funds (ETFs) might seem like perfect vehicles for dollar-cost averaging because they're known for their smaller expense ratios. But initial appearances can be deceiving. Transaction costs can quickly add up when you use an ETF as part of a dollar-cost averaging investment strategy. Those added costs can overshadow the benefits of DCA.

Comparing Expense Ratios

Many investors scrutinize a mutual fund's expense ratios when comparing investment costs. ETFs are quite similar to mutual funds so many investors try to compare costs by making a direct comparison of ETF and mutual fund expense ratios.

ETFs typically win in such a direct comparison, but this is changing. The Vanguard Group, known for low-cost, no-load index funds, competes with the low expense ratios of many ETFs. At 9.5 basis points (0.0945%), the popular SPDR S&P 500 ETF (SPY) was more than double the 0.04% fee charged by the Vanguard Index 500 Fund (VFIAX) as of February 2024.

Mutual Fund Fees vs. ETF Fees

The mutual fund expense ratio covers investment management fees, administrative expenses, and 12-b1 fees, which are a type of marketing cost). However, brokerage transaction commissions and sales charges (for load funds) are not included in the expense ratio.

Some mutual funds charge a fee if the account balance is below a certain level. This fee is generally $25 or less per year and is imposed if the account balance falls below a specific dollar figure. Vanguard's fee was $25 per year per account for account balances below $5 million as of February 2024.

Some funds also charge a purchase fee on each transaction or an exchange fee if assets are moved to another fund. Many mutual funds will also charge a redemption fee if assets aren't held in the account for at least a certain period.

Calculating the cost of investing in an ETF is a bit easier than calculating the cost of investing in a mutual fund. ETF investors can focus on just two items Instead of delving deep into a dense mutual fund prospectus: the expense ratio and the commissions for each ETF purchase within the dollar-cost averaging strategy.

The expense ratio of an ETF is a fixed-rate percentage of assets invested, just like the expense ratio of a mutual fund. But ETFs are bought and sold through a brokerage firm like shares of stock so there's also a commission that must be paid for each purchase or sale of ETF shares.

Some online brokers offer commission-free trading and others might charge a fee per share but the most common commission structure is a flat fee per trade. Commissions are the key item that investors want to consider when adding exchange-traded funds to a dollar-cost averaging approach.

Factoring in the Costs of Trading ETFs

Determining the expense ratio is the easy part when computing the costs of a dollar-cost averaging approach with ETFs.

The ratio is a fixed percentage of the investment so it has the same impact regardless of the amount of money invested. The cost of the expense ratio is nine cents on a $100 investment and 90 cents on a $1,000 investment if the expense ratio is nine basis points. The expense ratio is fixed so it doesn't matter if the investment is large or small because the percentage remains the same.

Commissions are a different story. Trading costs from commissions add up quickly and detract from performance so dollar-cost averaging into ETFs with small dollar amounts isn't always practical.

The expense ratio takes the same bite out of each dollar amount invested but a flat-rate brokerage fee or commission can take a large chunk out of small periodic investments, even with a discount broker that charges only a flat rate of $10 per trade.

The Impact of ETF Trading Costs

Consider the impact of trading costs on the following investments:

• The net investment after trading costs are subtracted is $15 on a $25 investment with trading costs of $10, The percentage of your investment that disappears as a result of trading expenses is 40%.
• The net investment is $40 on a $50 investment with trading costs of $10, The percentage of your investment that disappears as a result of trading expenses is 20%.
• The net investment is $90 on a $100 investment with trading costs of $10. The percentage of your investment that disappears as a result of trading expenses is 10%.
• The net investment is $990 on a $1,000 investment with trading costs of $10. The percentage of your investment that disappears as a result of trading expenses is 1%.

The impact of the trading costs from commissions only goes down if you invest more in larger lump sums but the goal of dollar-cost averaging is to invest small amounts regularly and more frequently. Brokerage commissions can overshadow the benefits gained from dollar-cost averaging in ETF investing unless the amounts you invest regularly are fairly large.

The Bottom Line

ETFs can be excellent vehicles for dollar-cost averaging as long as the dollar-cost averaging is done appropriately. ETF investors can significantly reduce their investment costs if they invest larger amounts less frequently or invest through brokerages that offer commission-free trading.

Dollar-cost averaging with ETFs isn't a strategy that will work well for everyone but that doesn't mean it isn't worthwhile. As with all investment strategies, investors must understand what they're buying and the cost of the investment before they hand over their money.