February 7, 2005

It Pays to Buy Exchange-Traded Funds in Bulk

Feb. 3, 2005 -- One advantage of investing in mutual funds -- the ability to buy small amounts of shares -- doesn't carry over when investing in exchange-traded funds.

The reason: transaction costs connected with buying ETFs. For big purchases, commissions can amount to a small percentage, but for small ones they become much larger. For the same reason, dollar cost averaging, or investing the same amount of money at regular intervals, may not be the way to go for small investors buying ETFs.

"It is not cost effective to dollar cost average if you're squirreling away small amounts of money each month," said Srikant Dash, an equity index strategist at Standard & Poor's. That's because of brokerage commissions, he explained. "If you're putting away $100, and you're paying $10 in brokerage fees, you're straight away losing 10% every month."

ETFs also are not ideal for automatic investment plans unless you put in "substantial amounts," Dash said.

On the other hand, ETFs make sense if you're making large lump sum purchases to rebalance a portfolio annually, he said. Many have lower fees than the lowest cost index mutual funds.

In general, bulk investing in ETFs looks good because the flat transaction cost increasingly becomes a smaller percentage of 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, investors in ETFs don't pay taxes until they sell the fund.

People looking to make relatively even periodic investments should probably invest at least $1,000 per ETF trade, said James Ross, director of product development with State Street Global Advisors, one of the two largest ETF providers.

One option for investors who want to make automatic investments in ETFs is 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-$4 per transaction. ShareBuilder keeps these costs lower than other brokerages by consolidating the transactions into one big block trade, a company spokeswoman said.

ShareBuilder, which focuses on younger small investors, offers a tool called PortfolioBuilder that can be used to create a portfolio of ETFs. The product uses a questionnaire to determine things such as what a person is investing for, how much risk he is willing to accept, and how long he plans to stay invested. It also takes into account the investor's income and tax rate. It then suggests an ETF portfolio.

Amerivest, an online investment service offered by AmeriTrade Holding (AMTD), provides a similar tool that enables people to tailor a portfolio of ETFs. AmeriTrade currently does not impose 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.

The chart below shows the edge that a lower fee ETF has over an index fund over 10 years, assuming a lump sum investment of $10,000 with an 8% annual rate of return after fees and expenses. Investors in the ETF would have reaped an extra $191.74, or an extra $1,169.23, over the mutual funds at the end of the period.

Fund

Annualized Return (%)

Expense Ratio (%)

Total Costs ($)

Final Value ($)

iShares S&P 500 Index Trust (IVV)

8.0

0.09

193.73 (Assumes $10 transaction fee)

21,395.52

Vanguard 500 Index/Inv (VFINX)

8.0

0.18

385.47

21,203.78

AIM S&P 500 Index Fund/Inv (ISPIX)

8.0

0.65

1362.96

20,226.29

Contact Bob Keane with questions or comments at: bkeane@investmentadvisor.com.

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