ETFs Can Be a Terrible Choice for Monthly Investors

Corey —  December 14, 2009 — 4 Comments

       If you’re the least bit interested in investing, I’m sure you’ve heard of ETFs (exchange traded funds) by now. They’re often touted as the lowest-cost option for investors who don’t want to pick individual stocks. Even my beloved Vanguard has begun pushing their ETFs much more than their index mutual funds – citing the lower expense ratios of the ETFs.

       But in all the fanfare about how cheap ETFs are, we seem to lose sight of the fact that you have to pay commissions when you buy or sell ETFs on the stock market. On the other hand, there is no cost to buy or sell mutual funds directly from Vanguard. There’s also the problem of bid/ask spreads on ETFs and premiums/discounts over the NAV (net asset value) of ETFs. I don’t have the data to analyze those costs, and it’s not possible to fully know the impact of those costs (because it depends on future prices as well).

       However, we can ask ourselves if the lower expense ratios on ETFs will offset the trading costs we have to pay to buy and sell them. This is a relatively easy question that just requires some math.

How Often Are You Trading?

       The more frequently you buy or sell ETFs, the more you’ll pay in trading commissions. So if you’re investing a certain dollar amount every month (also called dollar cost averaging), you’re going to pay one commission fee for each ETF in your portfolio every single month. (The same applies if you’re selling every month to generate income from your portfolio, though you probably won’t sell from every single ETF every month.)

       Those trading costs can add up very quickly and easily overcome your savings on the expense ratios.

A Cost Comparison

       Let’s use a simple example to see why you need to carefully consider all the costs involved with ETFs. We’ll assume you’re investing in a 100% stock portfolio that duplicates the world markets. That means you’d have 40% in U.S. stocks and 60% in International stocks. You could do this using Vanguard’s Total Stock Market Index and Total International Stock Index mutual funds. Or you could use Vanguard’s Total Stock Market ETF and FTSE All-World ex-US ETF. Your portfolio expense ratio for a 40% U.S./60% International mix would be:

  • Vanguard Mutual Funds – 0.28%
  •        

  • Vanguard ETFs – 0.19%

       That’s a difference of 0.09% – meaning that you’d save 0.09% of your portfolio value every year if you used Vanguard’s ETFs instead of their Mutual Funds. So what does that mean in dollars? It depends on how much you have to invest.

  • $10,000 to invest = $9 saved per year
  • $25,000 to invest = $22.50 saved per year
  • $50,000 to invest = $45 saved per year
  • $100,000 to invest = $90 saved per year

       This holds true until you have $250,000 invested, because at that point you can get a lower expense ratio on the Total Stock Market Index mutual fund – bringing the total expense ratio for the mutual fund portfolio down to 0.24% and lowering your savings to 0.05%.

  • $250,000 to invest = $125 saved per year
  • $500,000 to invest = $250 saved per year
  • $1,000,000 to invest = $500 saved per year

       So you can see the cost savings isn’t quite as great as the media makes it out to be. Yes, $500 saved is $500 saved – but you need $1,000,000 to invest before you’ll realize that kind of savings every year!

       Then we need to consider your trading costs for using the ETFs. The lowest commissions I’ve found are at TradeKing where they charge $4.95/trade or Zecco where they charge $4.50/trade. Here’s what your costs would look like for a 2 ETF portfolio if you’re using TradeKing (you’d save a little more by using Zecco):

  • Trading once per year – $9.90
  •        

  • Trading twice per year – $19.80
  •        

  • Trading six times per year – $59.40
  •        

  • Trading twelve times per year – $118.80

       So if you’re trading six or more times a year (buying or selling both ETFs in your portfolio) and you have less than $25,000 invested, you’re better off just getting the mutual funds directly from Vanguard (because you won’t have to pay trading costs). You could lower your trading costs by only buying one ETF at a time and only buying or selling once or twice a year, but that is not how most people invest.

       After you have $25,000 to invest you could use Zecco and get 10 free trades every month. But that $25,000 minimum balance for free trades applies to only one account, so if you have multiple accounts (more than one IRA, or an IRA and a taxable account) you can only get the free trades on one of them. If you’ve only got one account and you’ve got more than $25,000 to invest, then using Zecco to buy Vanguard ETFs could be a good choice. But there is a $30 annual fee for IRAs at Zecco, which will still eat into your cost savings (plus another $30 IRA closing fee if you ever decide to move to another brokerage firm). If you want to open an account at Zecco, you can go to their website.

It Only Gets Worse

       We only looked at a very basic portfolio in that cost comparison. But what if you want to invest in a more diversified portfolio or you want to add bonds? The trading costs only get higher and higher, unless, of course, you can use Zecco’s or another brokerage firm’s free trades program.

       However, as I pointed out, those free trades programs are generally quite limited and may carry other costs like annual service fees. You also have to deal with the uncertainty of whether those programs will continue. Once the terms of the free trades program changes (as they have in the past), you may end up paying a lot more in commissions than just $4.95/trade.

       You won’t run into those problems if you’re buying and selling mutual funds directly from Vanguard. And in many cases, you’re better off going that route anyway. Especially considering that the cost savings on ETFs don’t really amount to much even if you have a large portfolio. Add in those unknown costs of the bid-ask spread (probably negligible) and NAV premium/discount (could be a problem depending on when you buy/sell) and you have another variable in the equation.

Make Sure ETFs Make Sense for You

       The point of all this is not to say that you should never use ETFs. The point is that you should carefully weigh the costs of using ETFs against the savings. That’s the only way you’ll know for sure if ETFs are actually a good choice for you.

       Or you can just ignore the math, listen to all the financial “experts” on the TV, and do what they say. It’s up to you.

Corey

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Corey is currently pursuing a Master of Arts degree in religion. While he enjoys learning and writing about Christianity, another one of his new passions is writing about personal finances in order to help others make wise decisions with their money.

4 responses to ETFs Can Be a Terrible Choice for Monthly Investors

  1. AWESOME write-up. I’ve been trying to tell people the same thing for a while now: ETFs are cool and all with the flexibility that they give you. But they aren’t ideal for everyone, especially if you’re contributing on a regular basis.

    Well done!

  2. Writers Coin:

    Thanks so much for taking the time to comment! I’m glad you liked the article. This is just like every other personal finance decision. You can’t just take the common advice and expect it to necessarily apply to you. You can learn from it, but you should evaluate your own situation to see if it’s good for you or not. Thanks again for commenting. I hope to see you around more!

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