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.