Sometimes, the behavior and scope of capital markets goes
beyond conventional research and financial logic. This is one of
the major reasons for huge volatility witnessed in the financial
markets, and it has pretty much been the state of affairs for
investors for quite some time now (read
What Do Quarterly Trends Reveal about ETFs in
Q4?
).
While there are tons of ways in which an investor can ride
this uncertainty, not all of them prove to be fruitful. In the
light of the above statement, we would like to discuss one such
strategy which has time and again proven to be helpful to
investors.
Dollar Cost Averaging
This investment strategy involves allocating a fixed sum of
money to a particular investment avenue at regular intervals,
irrespective of the bullish or bearish bias in the market.
For example, you allocate a sum of money (say $1,000) to buy
shares of SPY on the 1
st
of every month for 12 months. This implies that irrespective of
the market conditions (i.e. bullish or bearish), you will buy
equivalent number of shares of SPY worth $1,000 every month at a
specified date.
As a mathematical implication of this phenomenon, with your
investment amount being constant (i.e. $1,000), you will buy more
shares when the prices go down and less shares when the prices
are up (both offering substantial room for capital growth) (see
more in the
Zacks ETF Center
).
By doing this investors i) don't have to worry about timing
the market, ii) can potentially bring down their average cost of
investment, iii) reduce volatility to a great extent.
ETF Approach to DCA
This strategy can be applied to any investment vehicle;
however, it is particularly intriguing when it is tried with
ETFs
. Their i) flexibility in terms of ease of trading ii) low cost
structure and iii) basket approach which reduces concentration
risk, make them appropriate avenues for dollar cost
averaging.
Let us understand how this strategy would work with ETFs with
a help of a real life example based on real events. The time
horizon is 18 months from Jan 2011 to June 2012 and it is assumed
that the shares are bought on the first trading day of each month
at their then market value.
The time horizon taken into account was an extremely volatile
period and three distinct broad market ETFs are considered as
these ETFs would serve as a pretty good sample to reflect the
total equity market sentiment in the U.S (read
Comprehensive Guide to Total Market ETFs
). These ETFs are -
Vanguard Total Stock Market ETF (
VTI
), Schwab U.S. Broad Market ETF (
SCHB
) and iShares Dow Jones U.S. ETF (
IYY
)
.
The following table shows the number of shares bought monthly
for $5,000 at the then market prices for three distinct broad
market ETFs for a period of 18 months (i.e. 1.5 years). At any
date, the number of shares is ascertained by dividing the
investment amount (i.e. $5,000) by the current market price as on
that date.
|
Date
|
Market Price (VTI)
|
No. of Shares (VTI)
|
Market Price (SCHB)
|
No. of Shares (SCHB)
|
Market Price (IYY)
|
No. of Shares (IYY)
|
|
Jan 2011
|
63.43
|
79
|
29.72
|
168
|
62.07
|
81
|
|
Feb 2011
|
65.13
|
77
|
30.53
|
164
|
63.88
|
78
|
|
March 2011
|
65.32
|
77
|
30.62
|
163
|
63.97
|
78
|
|
April 2011
|
67.04
|
75
|
31.4
|
159
|
65.51
|
76
|
|
May 2011
|
68.53
|
73
|
32.11
|
156
|
67
|
75
|
|
June 2011
|
66.38
|
75
|
31.12
|
161
|
64.92
|
77
|
|
July 2011
|
67.66
|
74
|
31.72
|
158
|
66.18
|
76
|
|
Aug 2011
|
64.9
|
77
|
30.45
|
164
|
63.55
|
79
|
|
Sept 2011
|
60.53
|
83
|
28.42
|
176
|
59.33
|
84
|
|
Oct 2011
|
54.71
|
91
|
25.73
|
194
|
53.74
|
93
|
|
Nov 2001
|
61.34
|
82
|
28.81
|
174
|
60.09
|
83
|
|
Dec 2011
|
62.78
|
80
|
29.46
|
170
|
61.48
|
81
|
|
Jan 2012
|
64.29
|
78
|
30.21
|
166
|
63.06
|
79
|
|
Feb 2012
|
67.38
|
74
|
31.61
|
158
|
65.82
|
76
|
|
Mar 2012
|
69.95
|
71
|
32.81
|
152
|
68.43
|
73
|
|
April 2012
|
72.15
|
69
|
33.84
|
148
|
70.64
|
71
|
|
May 2012
|
71.55
|
70
|
33.56
|
149
|
69.99
|
71
|
|
June 2012
|
64.95
|
77
|
30.49
|
164
|
63.69
|
79
|
|
Total No. of Shares
|
|
1,381
|
|
2,943
|
|
1,410
|
The table suggests that as the market price increases, fewer
numbers of shares are bought; however, as the prices go down, a
greater number of shares are bought (obviously). Nevertheless,
the total number of shares bought for VTI over a period of 18
months is 1,381; for SCHB it is 2,943 and for IYY it is 1,410
(read
Guide to Most Popular ETFs
).
Payoff at Redemption
|
Data Point
|
VTI
|
SCHB
|
IYY
|
|
Total No. of Shares Bought (A)
|
1,381
|
2,943
|
1,410
|
|
Redemption Price (B) (as of 30
th
June 2012)
|
$69.36
|
$32.52
|
$67.82
|
|
Redemption Value (A*B)
|
$95,786.16
|
$95,706.36
|
$95,626.20
|
|
Total Investment (18 months * $5000)
(C)
|
$90,000
|
$90,000
|
$90,000
|
|
Average Cost per share (C)/(A)
|
$65.18
|
$30.58
|
$63.83
|
|
Internal Rate of Return (IRR)
|
0.65%
|
0.64%
|
0.64%
|
|
Annualized IRR
|
8.08%
|
8.00%
|
7.89%
|
|
Annualized Return (in case of a lump sum
Investment of $90,000 instead of annuity over a period
of 18 months)
|
6.14%
|
6.19%
|
6.08%
|
Although a lump sum investment in each of the ETFs would have
resulted in a larger capital appreciation than dollar cost
averaging in terms, yet on an absolute basis, the
annualized rate of return
on dollar cost averaging investments is superior to that of a
lump sum investment.
This has happened because of the fact that with a lump sum
investment a larger portion of funds are tied up. However, on the
basis of annuity, the entire investment amount is spread out over
a long period of time and the investor has funds at his/her
disposal in case he/she needs it and availability of money is a
very big factor to consider before selecting an investment
avenue.
Therefore the technique also factors in the
opportunity cost
(i.e. the returns that would have been generated from the next
best investment avenue) of the lump sum investment (read
Two ETFs up more than 140% YTD
).
We use the annualized internal rate of return to ascertain
investment returns on an annuity basis and compounded annual
growth rate to measure returns from a lump sum investment.
The table above suggests that on an annualized basis the
investment of $90,000 over a period of 18 months would have grown
by 8.08%, 8.00% and 7.89%, respectively, for VTI, SCHB and IYY,
in case of dollar cost averaging, but the same $90,000 would have
grown only 6.14%, 6.19% and 6.08% in case of a lump sum
investment.
Drawbacks
It is true that dollar cost averaging significantly reduces
the probability of huge losses; however, it also limits the
upside potential significantly. Of course, using this investment
strategy, an investor does not need to worry about timing the
market but if one is confident of the direction of market
movement, a lump sum investment would any day be a better
option.
Nevertheless, dollar cost averaging can prove to be a great
choice for investors in an uncertain and highly volatile market,
like the one we find ourselves in now (see
Uncertain about the Economy? Try Market Neutral
ETFs
).
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Research? Today, you can download
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.
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ISHARS-DJ US IF (IYY): ETF Research Reports
SCHWAB-US BR MK (SCHB): ETF Research Reports
SPDR-SP 500 TR (SPY): ETF Research Reports
VIPERS-TOT STK (VTI): ETF Research Reports
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