How do you start out by investing in ETFs / stocks?

January 9th, 2009 · No Comments

I recently read an article entitled The best (and cheapest) funds around which purports to tell you when to invest using mutual funds vs. ETFs based on a cost analysis.  Unfortunately, they make a few too many generalizations that simply aren’t universally true and so I disagree with their results.  (Though I do agree with their analysis of annual expense fees.)

Be wise about your money and it will last longer

Be wise about your money and it will last longer

For example, they state “you have to buy ETFs in whole numbers of shares” but at places like ShareBuilder you CAN initiate purchases in an ETF using fractional shares.  I know because I’ve done it — I bought exactly $300 worth of NLY when the price was not evenly divisible into that amount.  The article uses this as one of the two main reasons to direct people to buy mutual funds if they’re in the “accumulation stage of your life”.  The other reason is the transaction costs related to purchasing ETFs.  But let’s be fair here, the universe of low-expense, high-quality mutual funds with no minimum investment amount is very small.  In most of my research, the minimum for a low cost index fund is around $2,500.  But if you have that amount in your portfolio, places like Zecco will give you free equity trades which means you pay $0 to buy and sell ETFs.  And suddenly you’re talking about having no difference in transaction costs.

But what about if you don’t have $2,500 in your portfolio and want to start out making periodic investments?  In this case, there are brokerages that will waive the initial minimum investment if you schedule automated, recurring purchases of a mutual fund — mostly brokerages run by fund family companies such as Fidelity, Vanguard, etc.  But you’re going to want to pick carefully because most such plans will result in a large, so called “short-term” fee should you choose to change your investment within 90 days, and in some places even within 180-days.  Additionally, you will be restricted to investing in only that brokerage’s universe of no-load funds if you want to maintain your $0 transaction cost purchases.   We’ve personally made the decision that flexibility in both time and the universe of investment choices is worth the transaction costs, as long as we can keep the transaction costs below 1.0% on purchases.  (That number is what it is partly because it means total annual expenses are still less than many actively traded mutual funds expenses.)

Here is an outline of our strategy for starting a portfolio using ETFs / stocks:

  • Start with a low-cost broker that allows purchases of fractional shares.  (So far, I’ve only found one: ShareBuilder)
  • Only make purchases when our investment amount is such that the transaction costs are less than 1.0%.  In our case, this means we need to invest at least $300 since we get a 25% rebate on fees due to having a Costco affiliation with our account.
  • Plan to switch to a no-transaction-cost broker once our portfolio gets large enough.  For example, if we have $2,500 we can open a Zecco account and make 10 free trades per month.
  • In the interim, we can change what we invest in each time we make purchases thus allowing for things like sector diversification.  But this will mean we need to stick with ShareBuilder longer since we don’t want to pay too much in transaction fees when we sell our investments in order to change brokers.  If we can invest $300 each month, we’ll be about ready to change to Zecco after about a year even if we’ve invested in two or three different ETFs / stocks.  The cost to us will be less than $25 to transfer our positions (3 x $7.46 sell, 3 x $0 buy)

    EDIT: I just read the fine print on the Costco/ShareBuilder association and it turns out there is no Costco rebate on what ShareBuilder calls “Real Time Trades”, which all sales are.  Thus the cost to sell would be 3 x $9.95 = $29.85.

For more details, see my post Our brokerage decision and a corresponding cash flow plan for 2009.

Tags: ETFs · Investing

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