ETF vs Mutual Fund in Roth IRA

If the type of investment is available in both fund and ETF choices, and the expenses are similar, you are better off with the fund.

There are some reasons why in a post tax (non 401(k) or IRA, I mean) account the ETF may have advantages. Depending how tightly you manage your money with an eye on taxes, a fund's year end distribution may be very unwelcome.

In your case, you mention funds with as high as 1.2% expenses. Is the same type of investment available as an ETF with even a .7% expense? If so, you need to do the math. .5% on $2000 is $10 which should cover the commission on the ETF. If the saving is less, the break even is longer. I see you making 8 transactions a year, you might consider cutting it down to 6 or even 4 to reduce expenses. How about (in 2008) loading the

JOE

Please clarify? I've read in various places that given two similar investments the ETF will often outperform solely based on the lack of active management (read: market timing) that is otherwise present in most funds (average fund turnover is 89%). According to the S&P Index versus active report (SPIVA) active managers rarely outperform the market over any significant time period, so why would you take the actively managed fund over the passive ETF if expenses were similar?

I am assuming you mean that the funds are a better buy because the lack of a bid-ask spread and no transaction costs? If so, that is most definitely an advantage of MFs. Some would argue that being able to buy and sell ETFs at any time during the day can compensate for this. I'm not a big market timer so I'll stay away from this one.

Very good point. There are plenty of low cost funds out there, but according to morningstar the average expense ratio of ETFs in 2006 was

Maybe the assertion was about ETFs vs. comparable INDEX funds.

The point I was trying to make (and failed, perhaps) is this; let's compare VFINX to SPY, for example. Above, I say 'type' to try to get as 'apples to apples' as I can. I am big on recognizing the variables and freezing the ones I can. VFINX has .18% expense, SPY, .08%. Recall, the OP is using retirement accounts, and therefore any discussion of tax consequences is valid, just not to him. There's a variable or two frozen there. Assume a $10 commission. For $1000, that represents 1%, or about

For those with this investment in a post tax account, the ETF may be favored as it avoids the risk of cap gain distributions which may mess up one's tax planning. Or favor the fund, as it can be used for easy rebalancing and sales to create a loss or gain if needed.

The choice isn't clear cut, it really depends on one's intent and detailed background info. I hope that clarifies my first remarks.

JOE

Makes perfect sense now. As Beliavsky stated above, I was not looking purely at index funds, but all mutual funds. Many actively managed MF perform worse than their respective benchmarks/ETFs. Index funds do not have that problem however.

kastnna

Hi Joe,

Thanks much for the comments and expertise. I wonder if any studies have been done on frequencies of dollar cost averaging? In other words, if I'm only investing twice/year versus month/weekly, or even daily, is that still dollar cost averaging? Is there any optimal frequency? There is an obvious trade-off between advantages of dollar cost averaging and the cost of doing so in ETFs with their obvious advantages of low cost.

Actual Dollar cost averaging has been proven inferior to investing a lump sum immediately.

What you propose is a way of putting new money into the funds or ETFs. I'd think one can 'do the math' given the values for the variables; $$ amount per period, commission cost for ETF, assumed market return, current return on cash. This may turn into an "angels on the head of a pin" discussion, as it seems to me that on $1000, MM = 5% and even with assumed stock return of 8%, that's just $30/yr or $2.50/mo. So, you lose $2.50 by waiting one month, but save the commission, say $10, by grouping two months into one purchase. There's nothing wrong with going the fund route until the dollars are more significant and maybe once every year or so converting some amount to the ETF. That help? JOE JoeTaxpayer.com

It would help to know how large an investment we are discussing. In your case, it sounds like you are "forced" to DCA. As you make the money you invest it. You are not sitting a large pile of cash that you are slowly integrating into the market. If that is the case, you have no choice but to DCA (at least to some extent). Transaction costs are fixed, not variable. What you should do largely depends on how much of an impact these fixed costs have on your investment. A good goal would be to keep transaction costs below a certain level (perhaps 1% or

It helps to look at the situation in extremes. Assume a $10 trade charge. If you are depositing $20 a week, you would lose half your money just to transaction costs if you purchased ETFs weekly. You would need a 100% annual return just to get back to even! On the other hand, if you were depositing $20,000 a week, I would say go for it. In the latter case, fixed costs only erode 0.05% of your investment. That should be easy to recover.

immediately.http://www.altruistfa.com/readingroomarticles.htm#DollarCostAveraging> It feels better, and would keep one from investing too much money the> month the market peaks, but the link has multiple articles supporting > this view.

Hi Joe,

I would think that the scenario the authors of the article you site would be seen relatively infrequently. That is, how often do people receive a large, lump sum of money they have to invest? Most people have some amount they have from each paycheck of periodically that they have to invest. The other option is to not invest the small sums they have and save them all until they are large sums and then invest them. But, I suppose the gist is that most people who are ostensibly dollar cost averaging are really just investing whatever funds they have available at the time. Not sure if that makes sense or not, but I guess that relatively speaking the average Joe is investing his lump sum each time he gets a paycheck instead of immediately when he receives his lump sum from his rich uncle.

======================================= MODERATOR'S COMMENT: Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.

Yes, my point really was that most people are forced to DCA as they do not have a big pile of cash. In the end, my question (or now it's not really question but rather a point) is what is the optimal investment strategy for the average investor. In most cases where a workplace account is in play there is not much choice in the matter -- the employer routes a certain percentage of the gross income to investments each time the individual gets paid. This is DCA whether the investor likes it or not and is optimal in that the amount the individual has to invest is indeed invested as soon as it becomes available, the pros/cons of DCA notwithstanding.

Then, there is the case of an IRA/Roth IRA where there is more choice in the frequency/amount to invest. What I suppose the article Joe Taxpayer quoted is saying is that the best way to invest, if the individual had the funds at the time, would be to drop the entire maximum allowed contribution in the market at the beginning of the year. This would minimize the cost in an ETF as there is a single transaction. I can't imagine that Joe would advise to follow this strategy is the market is at a 52 week high at the time, though.

Why not? Joe doesn't seem to be the market-timing type.

-Will

Right Will. MJ - the link earlier in this thread contained seven further links to articles all concluding the same thing. My acceptance of their conclusion doesn't change based on the market being at a high, because as Will offered, that suggests market timing. When one of my clients found herself with a lump sum to invest, I quickly had to accept the fact that she felt similar to hoe you appear to feel, that some how there's more risk at such a high. Knowing when to give up, we invested the money about 5% at a time over a two year period. Look at a long term graph of the S&P. She missed much of the move from 1996-8. Most of the

JOE JoeTaxpayer.com

I suppose it's again a question of the individual strategy. If one's strategy is to buy and hold for the long-term versus trying to time the market then I suppose it's a lot less counterintuitive to invest as much as one has to invest regardless of where the market is at the time. A lot of the literature talking about why not to invest when the market is high seems to be written by and for 'professional' investors who probably change positions more frequently in week then I do in 2 years.

What is your time horizon? If you plan on leaving this money invested for a long time, you should have much less concern for the markets highs and lows. Even if it falls right after you invest, it should recover given a long enough time horizon (past performance not indicative of future performance yada yada...). Many of the tech investors of 2000 that lost 1/2 of their investment have since returned to their original levels (or better). If you need the money in the near future (2-5 years) then maybe DCA is best anyway. It will mitigate an early market downturn. But for long term investments, don't worry about it.

As for the "forced" DCA and how frequently you should purchase topic: As I said above, it depends on how much you plan to invest. I try to keep transaction costs between 0.5 and 1%. For $10 transaction costs this means I don't invest until I have between $1000 and $2000 saved up. If you can save that much in a week, then invest every week. If it takes six months to save up that much then purchase every six months. There's no universal answer, its a function of investment amount and transaction costs.

I completely agree on both topics. I have learned something new as in the past I have invested quarterly in my and my wife's Roth IRAs believing that doing so was preferable to investing all at once or less frequently. Now, I will attempt to switch as much as possible to ETFs to lower costs (not that most of mine are high, anyway, but even small differences matter long-term) and invest perhaps twice per year as close to the beginning of the year as possible to have the funds invested the longest possible and also to minimize transaction costs. These are all retirement funds for maybe 25 years from now.