ETFs are different from index funds and other types of mutual funds, primarily in that they can be traded throughout the day on the stock exchanges. For this reason, you can choose to invest as little as the cost of a single share. Unlike index funds and other mutual funds, which are bought and sold from the fund sponsor directly or indirectly through a brokerage, ETF transactions are between individual investors on the exchange.
There’s a saying that ETFs are traded in shares, while mutual funds are traded in dollars. What this means is that you can make a $1,000 trade in a mutual fund or index fund, and the entire amount will be invested in the fund; you are able to buy fractional shares. When you buy ETFs, however, you specify the number of whole shares you want to buy; a $1,000 investment would have some amount of cash left uninvested after the last full share is paid for.
Most mutual funds and index funds have minimum investment requirements. These are typically in the neighborhood of $2,500 or $3,000, although some have minimums as low as $100. As a rule of thumb, funds with the lowest expense ratio, or percent of assets charged to cover management costs, have the highest minimum investment. For example, Vanguard offers two classes of index funds tracking the S&P 500; VFINX requires a $3,000 initial investment and has an expense ratio of 0.16%, while the “admiral class” fund, VFIAX, has a $10,000 minimum investment, but an expense ratio of just 0.05%.
Although the lack of a minimum investment requirement puts ETFs within reach of even the smallest investors, it’s important to keep in mind that you’ll pay broker’s commissions and fees whenever you buy or sell ETFs. These fees typically range between $4.95 and $19.95 per trade, with the average hovering around $10.
In other words, if you decide to open a brokerage account with $100 and use it to buy shares of an ETF trading at $25, you’ll only be able to buy three shares, and you’ll waste about 10% of your investment right up front on commissions.
Some ETFs trade commission-free when you buy directly from your account with the fund sponsor. Vanguard, for example, has a number of commission-free ETFs if you open a Vanguard account, so if you plan to make regular, smaller share purchases, you should look for investment companies that offer commission-free ETF options. Otherwise, your trading costs will wipe out your gains and probably even put you in negative territory over the course of the year.
While commission-free ETFs are the exception rather than the rule, most index funds have no transaction costs. Index funds tend to be the more attractive option for smaller investors who want to invest a certain amount on a regular basis. While traditional mutual funds generally have much higher expense ratios than ETFs, index funds have low expense ratios, often on a par with ETFs. You may, however, have to maintain a minimum account balance in order to avoid service fees.
If you plan to make just a few large share purchases per year, ETFs may be the most efficient investment option, because your commission costs will not affect overall returns. If you are a small investor planning to make monthly or semi-monthly purchases, perhaps through an automatic investment plan deducted from your paycheck, an index fund is likely the more economical option, even if you need to save up a few months to reach the minimum initial investment.