The Dangers of Dollar-Cost Averaging Small Amounts with ETFs By IndexFunds.com Staff January 24, 2003

Exchange-traded funds often have lower expense ratios than comparable traditional index funds. However, since ETFs trade like stocks, investors must pay commissions every time they buy or sell shares. Therefore, it might not make sense to dollar-cost average with small amounts using ETFs because the commissions may end up more than negating the lower expense ratios of ETFs.

Investors who dollar-cost average contribute fixed amounts to funds in their portfolios on a strict schedule - every month, for example. For investors who contribute relatively small amounts per month, say $100 each month, traditional index mutual funds may be the better choice.

To illustrate this, we used Morningstar's Cost Analyzer tool (available only to premium members) to see how the Vanguard 500 index fund (VFINX) stacked up against SPDR 500 (SPY). 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%.

We set up the cost analyzer to assume:

• 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 cost analyzer spit out the following:

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

As we see above, those commissions can add up over time. According to the results of the 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.

Although the cost analyzer is only a simulation that requires arbitrary inputs, it does a good job of at least illustrating the dangers of dollar-cost averaging ETFs with small amounts. Exchange-traded funds make more sense for investors who invest a large lump sum, and the tax advantages of ETFs may also be more meaningful in this situation.

"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.

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.

We're also showing only one comparison above. 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.

However, Traulsen noted the cost analyzer doesn't 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.

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.