Innovation in the financial market usually gets a bad reputation from portfolio insurance to CDOs. Exchange traded funds is a natural extension of index funds and is one of the better technological development in finance. It has effectively democratized cheap and efficient means for individual to gain exposure to the market.
Stock picking has always been synonymous with investing. The shift from active to passive investing in the last 3 decades has fueled the growth of the index funds and the proliferation of ETFs. The ASX ETF list shows there are now hundreds of funds available on the Australian stock exchange.
Either consciously or subconsciously the main purpose for investors choosing to buy stocks is picking winners and beat the market. ETFs aims to capture the performances of a portfolio stocks which tracks the a particular market index.
For investors, the decision of choosing between ETF vs stocks depends on individual circumstances but we have highlighted some of the major differences and key points of consideration.
Of the highlights of the differences between ETFs and stocks below, we are comparing owning ETFs versus investing through a portfolio of stocks. We do not recommend anyone should concentrate the investment portfolio in a single stock!
Ease of Portfolio Diversification
Diversification is one of the most important concept in finance and a crucial risk management tool for both short term traders and long term investors.
A diversified portfolio ensures all of the eggs are not in a single basket and the portfolio is not particularly exposed to negative performance of a particular stock. ETFs allows investors to immediately diversify the portfolio through a single investment and the risk profile of the portfolio can be further diversified through multiple ETF holdings.
The downside of a diversified portfolio is the performance of the individual stock performance is mitigated as the outperformed is washing through the rest of the portfolio.
At the other extreme, owning a portfolio individual stocks can provide diversification benefits, this is achievable at similar cost only for the larger investment portfolio. It is much more expensive or less effective for small investment portfolio to achieve a similar degree of diversification to comparable ETF option.
Dividend Yield Difference Between ETF and Stocks
Dividend yields can also vary between holding ETFs vs stocks directly. This is mainly because payout ratios differ between sectors and the yield on investment is dependent on the make up of the portfolio. As ETFs tracks markets in general, the dividend yield of the fund is the average of all of the stocks in the portfolio.
One of the main downside from owning ETFs is the inflexibility of creating yield in the portfolio as it is largely a fixed. For those that are income focused, this can be partially address by utilizing ETF which have a dividend focused strategies.
Investors will have greater flexibility in creating a yield portfolio by investing in stocks through the individual stock selection process. For example a yield filter can be used as one of the criteria in the investment evaluation process.
Market Beta vs Stock Picking Alpha
A long term ETF portfolio upside is capped at matching the performance of the market but at the same time the downside is limited where it is rare for the ETF to fail to track the market index effectively.
On the otherhand, stock picking is a double edged sword where if you are good a choosing stocks can outperform the market. At the same time for a vast majority of investors and even professionals it is hard to beat the market consistently.
A key consideration should be not only how confident you are in your stock picking skills but also the consistency of beating the market year in and year out.
Opportunity Cost of Portfolio Management
A key attractiveness of passive investment in addition to the low fees is the lower time requirement. Not everyone likes to always keeping an eye on the markets in their spare time and track the developments of the companies in the portfolio.
Exchange traded funds are a cost effective way of handing off tracking the investment management process to the market it self.
Managing your own investment can save on management fees but even as investors do their own stock picking, there is a high opportunity cost in finding ideas, evaluating ideas and narrowing the funnel into investing.
After deploying the capital, the positions needs to be tracked to ensure the company is performing inline with the original investment thesis. All of this takes time and more so for people with non-financial background.
Therefore sometimes owning an ETF is good enough for most comparing to the alternative of allocating the limited free time to managing the investment portfolio.
Ease of Market Access
The biggest advantage ETFs provide is it allows ease of access to different markets where it is not possible with investing in individual stocks.
For example it is difficult for Australians to invest directly outside of Australia through the existing brokerage platforms as there are numerous costs like margin for FX trades, only a select list of markets and it might not be the same as the markets you want.
ETFs provides an opportunity for immediate access to different markets and this can be sliced in to a number of perspectives. A shortlist of the breadth of the offer includes below from market wide options to niche options.
- Country ETFs for those that are looking to gain exposure to Japan can buy ASX Japan ETF
- Sector specific funds which tracks a particular segment of the market (i.e mining or financials)
- There is proliferation of smart beta ETFs which tracks the performance of particular investment factors.
For those that are keen or able to manage their own portfolio, you can do all of the above but ETF vehicle is a much more efficient means.