As ETF’s Proliferate, Are They a Better Buy Than Individual Stocks?

What are the top similarities and differences between individual stocks and ETFs? Tom Cleveland from www.forextraders.com examines below.   

The popularity of Exchange-Traded Funds, or “ETF’s”, has swept the investment community by storm and challenged the tight grip that the mutual fund industry has had on retail consumers looking for a managed path to investing success.  ETF’s got their start in the early nineties with equities, soon followed by Exchange-Traded Notes (“ETN’s”) that focused on bond-related securities.  From the initial index-type funds, the industry has grown to over 1,300 offerings with over $1 trillion under management.  Recent figures indicate that ETF/ETN turnover represents nearly 37% of all U.S. equity trading volume.

With results like these, should an individual investor shun owning stocks directly and concentrate on ETF’s instead?  The answer to that question depends on your personal investing style and tolerance for risk.  As an informed investor, however, it would make sense to understand the similarities and differences between these two investing options before making a final decision going forward.

                Similarities

The design of an ETF was crafted to address the apparent drawbacks of mutual funds and “mirror” the flexibility of trading individual shares on the market.  For that reason alone, the similarities between stocks and ETF’s are extensive:

• Both can be bought and sold at anytime during the trading day;
• Both can be shorted with similar rules applying to each;
• Options can also be bought and sold on each security;
• Margin borrowing can be used to leverage returns;
• Brokers handle both types on all exchanges.

In summary, the benefits of investing in stocks and ETF’s trump their mutual fund brethren in real-time pricing, liquidity, and general transparency.

                Differences

The differences are the compelling arguments for selecting ETF’s over individual stocks.  The major ones are as follows: 

• Diversification:  Investing is all about mitigating risk for reward, and ETF’s are excellent vehicles for spreading your risk over the several securities held by the fund.  Studies have confirmed that the benefits of diversification do not arise unless twenty or more securities are involved.  For consumers, it is extremely difficult to follow everything related to twenty or more separate entities.  The potential of being blindsided by bad results, an incompetent management team or CEO, or outright fraud is lessened when professionals are watching your back and the fund is widely diversified;
• Breath of Offerings:  ETF’s were originally designed to mimic the actions of specific indexes.  Over time, SEC rules were modified, and now an ETF investor can gain a position in a broad host of asset classes that were off limits or a direct and diversified basis.  These options include Commodities, Emerging Markets, Inverse or Leveraged Return products, Precious Metals, Currencies, Bonds, and just about any other sector of the economy;
• Volatility:  Diversification typically produces a lower “beta” for shares in a commingled fund rather than for shares in an individual stock.  Trading opportunities may be less, if trading for short-term gain is your objective, but ETF valuations will still move in wavelike patterns;
• Liquidity:  Arguments can be made on both sides for liquidity, but generally speaking, an ETF will have greater liquidity than will the individual stocks within its portfolio.

ETF’s definitely offer an easier way to invest with diversification benefits built in for peace of mind.  Clever investors can assemble a well-balanced portfolio by accumulating shares in a variety of specialized sector funds.  For the individual investor that has a higher tolerance for risk, a good source of potential investments can be gleaned from a review of the holdings in high performing ETF’s.  Performance reports typically list each holding by name and ownership percentage.