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Deciding Between Stocks and ETFs
Perhaps you’ve decided that you want to invest in a particular sector. Now you may be in the position of choosing between buying stocks or an exchange-traded fund (ETF).
Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. And of course, you want to generate a return that beats the market.
Key Takeaways
- When deciding between investing in individual stocks in an industry or buying an exchange-traded fund (ETF) that offers exposure to that industry, consider opportunities to best reduce your risk and generate a return that beats the market.
- Stock-picking offers an advantage over ETFs when there is a wide dispersion of returns from the mean.
- Exchange-traded funds offer advantages over stocks when the return from stocks in the sector has a narrow dispersion around the mean.
- ETFs can also be beneficial if you don’t have specialized knowledge that gives you an edge in evaluating individual companies.
The Goal: Achieving Alpha
Alpha is the ability of an investment to outperform its benchmark. Any time you can fashion a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you must own stocks, rather than an ETF, to beat the market.
In addition, many investors are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. Neither of these assumptions is necessarily true because it depends on the characteristics of the sector. Being in the right sector can lead to achieving alpha, as well.
Reducing Volatility
Investors also seek to mitigate risk, generally by reducing the volatility of an investment. Most investors give up some upside potential to prevent a potentially catastrophic loss. ETFs offer diversification across an industry group, which reduces the portfolio’s volatility. This is one way that diversification through ETFs works in your favor.
When Stock Might Be the Best Choice
Industries or situations where there is a wide dispersion of returns—or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing—offer stock-pickers an opportunity to exceed expected returns.
Based on your research and experience, you may have a good insight into how well a company is performing. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value-added investment opportunities, rewarding the stock investor.
The Retail Industry Lends Itself to Stock Picking
The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products they carry. This may create an opportunity for the insightful stock picker to do well.
For example, let’s say that you recently noticed that your daughter and her friends prefer a particular retailer. Upon further research, you find the company has upgraded its stores and hired new product management staff.
This led to the recent rollout of new products that have caught the eye of your daughter’s age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.
Note
Company insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a particular sector—and where there is much return dispersion—single-stock investments can provide a higher return than a diversified approach.
When an Exchange-Traded Fund (ETF) Might Be the Best Choice
Sectors with a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar.
For these sectors, the overall performance is fairly similar to that of any individual stock. The utilities and consumer staples industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks.
Since the dispersion of returns from utilities and consumer staples tends to be narrow, picking a stock does not offer a sufficiently higher return for the risk inherent in owning individual securities.
Note
ETFs pass through the dividends that are paid by the stocks in the sector, so investors receive that benefit as well.
Consider ETFs When Performance Drivers Are Unclear
Often, the stocks in a particular sector are subject to dispersed returns. However, investors cannot select securities that are likely to continue outperforming. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.
If the drivers of the company’s performance are more difficult to understand, you might consider the ETF. These companies may possess complicated technology or processes that cause them to underperform or do well. Perhaps performance depends on the successful development and sale of new, unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low.
Industries Where ETFs Are a Better Option
The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials (or the Food and Drug Administration (FDA) does not approve the drug application0, the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company may be highly rewarded.
Certain commodities and specialty technology groups, such as semiconductors, fit the category where ETFs may be preferred. For example, if you believe now is a good time to invest in the mining sector, you may want to gain specific industry exposure.
However, let’s say you are concerned that some stocks might encounter political problems that could hinder their production. In this case, it is wise to buy into the sector, rather than a specific stock, since it reduces your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.
In January 2024, the SEC approved spot market Bitcoin exchange-traded funds for the first time. Trading cryptocurrencies may be easier through an ETF than the traditional routes, which include using crypto exchanges, the need for a storage wallet, and the need to keep private and public keys. ETFs, in this case, are especially useful for those unfamiliar with the crypto world but would like exposure to cryptocurrencies.
What Are the Downsides to ETFs?
Though ETFs make buying a swath of stocks easier, allowing for exposure to certain sectors, they do come with downsides. The downsides include fees associated with investing in ETFs, though these are usually fairly low. There is also the risk that the fund may veer away from the benchmark it is meant to track. Additionally, there is diversification risk within each ETF as they are concentrated in a sector. Furthermore, there is less control for an investor as they do not get to choose the specific stocks, and if an investor is looking to beat the index, that is not the goal of an ETF, so returns may not be as high as some investors desire.
Do ETFs Pay Dividends?
Yes, they do, for the stocks that pay dividends. So for a stock that does not pay a dividend, an ETF investor will not receive dividends from the ETF. If the stock pays dividends, the ETF must legally pass that on to the investor.
Do You Actually Own Shares in an ETF?
You do not own the underlying stocks/assets in the ETF; you only own shares of the ETF. For example, if you invest in an ETF that buys shares of Apple, you do not own any Apple stock, you only own a portion of the ETF.
The Bottom Line
When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFs when there is a wide dispersion of returns from the mean. And with stock-picking, you have the ability to gain an advantage using your knowledge of the industry or the stock.
ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice.
Whether you are picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all your good work go to waste as time passes. While it’s important to do your research so you can be able to choose a stock or ETF, it’s also important to research and select the broker that best suits you.
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