Pro Tip: use mutual funds for dollar-cost averaging, then flip into ETFs to cut taxes and expenses

Exchange-traded funds (ETFs) are the greatest thing since sliced bread. They allow individual investors to build diversified portfolios at near-zero cost. You can get all the asset classes you need using only a handful of ETFs.

Here's a 4-ETF portfolio you could start with, choosing various weights depending on your risk tolerance.

VTI - Total US stock market
BND - Total US bond market
VEA - Foreign stocks
VWO - Emerging market stocks

Your total cost on that portfolio would be less than 0.1% per year.

If you want to get fancy, you could throw in a few other asset classes like REITs (VNQ and VNQI), munis (MUB, CMF, NYF), and high-yield bonds (HYG). There are even ETFs for the precious metals (SGOL, SIVR, PPLT, PALL...), though most goldbugs prefer, with good reason, to hold physical metal.

So what's the downside to ETFs for individual investors?  It's that you generally can't set up automatic dollar-cost averaging as you can with mutual funds.  I like to dollar-cost average into volatile, uncorrelated asset classes as a long-term savings strategy, putting $100 or so into a number of funds monthly.  Online trading platforms such as Vanguard, Fidelity, Schwab, and E-Trade can accommodate this easily.  But none that I'm aware of can do automatic periodic investing of fixed dollar amounts into ETFs.

For example, I want to dollar-cost average into mid-cap stocks.  The SCHM ETF is extremely cheap at 0.07% per year, but there's no way to set up automatic periodic investing in it.  So I'll dollar-cost average into the Dreyfus Mid-cap Index Fund (PESPX), which has much higher expense ratio of 0.50%, but allows automatic investing. Then I'll sell it all every year or so and swap into the SCHM ETF, so I'm only paying the higher expense ratio on my recent investments, and allowing the bulk of my mid-cap money to grow in the lower fee SCHM ETF.

Besides the higher expenses, there's another good reason to prefer ETFs over index funds: index funds may pay out capital gain distributions which are taxable to the current holders, even if the current holders did not own the shares long enough to participate in the appreciation. PESPX, for example, has paid out sizeable capital gains the last few years.  Switching from mutual funds to ETFs can help you avoid these unexpected tax bills.

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