Beware Small ETF Trades

Exchange-traded funds have many strengths, but individual investors should be wary of investing in small amounts. Transaction fees cannot be avoided with ETFs as they can by going directly to a traditional no-load mutual fund, because ETFs must be bought and sold like a stock through a brokerage house. For substantial purchases, this transaction fee is an insignificant percentage, but for small purchases it becomes unreasonable. Investors are encouraged to save until they can invest at least $1,000 per ETF trade.

Adding small fixed amounts to an account on a regular schedule, called dollar-cost averaging, is popular among individual investors. It ensures constant saving and helps to diversify returns. But it also rings up a high percentage of transaction costs, even with discount brokerage firms. To illustrate this, consider how the traditional Vanguard 500 index mutual fund (VFINX) stacks up against the SPDR 500 (SPY), an ETF, in a typical dollar cost averaging scenario. 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%. The analysis assumes:

• 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 results show the low annual fee of the ETF is not enough to overcome the transaction fee drag:

Source: Morningstar 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's and would have returned about half a percent more per year after costs, a significant amount over long time periods. The results illustrate the danger of transaction fee drag with dollar-cost averaging ETFs in small amounts.

In contrast, ETFs show strength when sums are invested in somewhat larger amounts, because the flat transaction fee becomes an increasingly small percentage of the account and the lower fees and tax advantages of ETFs becomes the driving force. Exchange-traded funds make more sense for investors who invest a large lump sum or whose regular deposits per fund are above $1,000. This kind of investor is encouraged to choose traditional mutual funds or make less frequent deposits to their account or keep cash in a money market account in the interim. The latter strategy just slightly lowers the investor's exposure to equities and thus to both the likely higher return and possible risk they bring.

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. There are many variations of the simulation that could be run to reflect an individual investor's situation. For investors who slice-and-dice the market with several ETFs, the commissions generated from contributing to multiple funds each month would drain portfolio returns.

The simulation does not take into account the low account balance fees charged by some index fund providers. 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 a certain amount. The simulation also does not reflect the transaction fees that investors may pay if they invest in mutual funds through brokerage firms as a convenience.

For most popular broad indexes, choosing between an ETF and an index fund depends on how much one has to invest at a time, how many funds are involved, and the commissions charged by the broker.