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By Richard Diennor One advantage of investing in no-load (commission-free) mutual funds -- the opportunity to buy a small number of shares without incurring transaction costs -- doesn't carry over when purchasing exchange-traded funds. The reason: ETFs trade like shares of common stock, so they incur brokerage commissions. That's not as big a concern when purchasing a large number of shares, as commissions can amount to a small percentage of the total invested. But for small purchases, the proportional bite enlarges.
For the same reason, the popular practice of dollar-cost averaging, or investing the same amount of money at regular intervals, may not make sense for small investors buying ETFs. "It's not cost-effective to dollar-cost average if you're squirreling away small amounts of money each month," says Srikant Dash, an equity index strategist at Standard & Poor's. Because of brokerage commissions, he explains, "if you're putting away $100, and you're paying $10 in brokerage fees, you're straight away losing 10% every month."
The same is true of load funds, where you might be losing 5% or more each month. Commissions generally range from 5% to 5.57% on load funds on the front end.
LUMP-SUM ADVANTAGE. ETFs are also less than ideal for another favorite vehicle -- automatic investment plans -- unless you put in "substantial amounts," Dash says. On the other hand, ETFs may make sense if you're transacting large lump-sum purchases to rebalance a portfolio annually, even taking the brokerage fees into account, he explains. Many have lower fees than the lowest-cost index mutual funds.
What's a better approach to buying ETFs? As with grocery shopping, it may pay to buy larger quantities at one time. In general, bulk investing in ETFs looks good because the flat transaction cost increasingly becomes a smaller percentage of the value invested in the account. At that point, the lower fees and tax efficiencies of ETFs become major factors. Except for dividends and occasional but rare capital-gains distributions, ETF investors pay no taxes until they sell the fund.
Those looking to make relatively even periodic investments should probably invest at least $1,000 per ETF trade, says James Ross, director of product development with State Street Global Advisors, one of the two largest ETF providers.
BARGAIN BROKERS. Investors who want to make automatic investments in ETFs can also opt to buy them through ShareBuilder Securities Corp., an online brokerage house. The majority of the firm's customers make automatic monthly investments that cost $1 to $4 per transaction. ShareBuilder keeps these costs lower than other brokerages by consolidating the transactions into one big block trade, a company spokeswoman says.
ShareBuilder, which focuses on younger small investors, offers a tool called PortfolioBuilder for creating a portfolio of ETFs. The product employs a questionnaire to determine why users are investing, how much risk they're willing to accept, and how long they plan to stay invested. It also takes into account the investor's income and tax rate. Based on this information, it suggests an ETF portfolio.
Amerivest, an online investment service offered by AmeriTrade Holding (AMTD
), provides a similar tool that enables users to tailor a portfolio of ETFs. AmeriTrade imposes no commission charges for ETF transactions in an AmeriTrade investing account. Instead, Amerivest charges a flat fee: 0.5% of assets for portfolios with less than $100,000, and 0.35% for portfolios with $100,000 or more.
COMPARE AND SAVE. In the end, it often boils down to the cost of holding a fund, not the cost of buying it. ETFs' lower expense ratios and fees can more than make up for the transaction costs of purchasing them.
The chart below shows the edge that an ETF with lower fees and expenses has over an index fund during a 10-year period, assuming a lump-sum investment of $10,000 with an 8% annual rate of return after fees and expenses. Investors in the iShares ETF would have reaped an extra $191.74 over the Vanguard index mutual fund, or an extra $1,169.23 over the AIM index mutual fund, at the end of the period.
WHERE ETFS HAVE THE EDGE
Annualized Return (%)
Exp. Ratio (%)
Total Costs ($)
Final Value ($)
iShares S&P 500 Index Trust ETF
Vanguard 500 Index Fund
AIM S&P 500 Index Fund
*Assumes $10 transaction fee. Diennor is a reporter for Standard & Poor's Fund Advisor