Stocks represent ownership interest in companies and trade on regulated and over-the-counter markets. Exchange-traded funds are investment vehicles that invest in multiple securities but that you can buy trade on the markets just like stocks. You can't fully predict the difference between an ETF and a stock in terms of returns, since nobody can fully predict the market, but you can choose which is right for your investment needs.
Stocks give you more degrees of control over your individual investments and let you invest in and potentially have a say in the management of particular companies, while ETFs let you either track a larger market index or defer to the wisdom of whoever is running the fund.
Owning individual shares lets you invest in particular companies, while buying ETFs lets you track broad swaths of the market or a set of stocks picked by a professional. ETFs can be inherently more diversified than any individual stock, though they usually carry some fees that stock ownership does not.
What's an ETF?
An ETF is an exchange-traded fund, meaning one where you can buy and sell shares similarly to buying and selling individual shares of stock. They usually have ticker symbols and can be bought or sold through stock brokerage firms for the commission you would pay to trade stocks.
Many ETFs are also index funds, which track specific market indexes, like the S&P 500 or the Dow Jones Industrial Average, or groups of stocks in particular sectors of the economy like energy or housing. Such funds are traditionally cheaper in terms of fees than mutual funds that pick stocks based on insights from professional managers, but you should look into how a fund you're considering chooses its investments, the fees it charges and its historical returns.
ETF Vs. Stock: Individual Control
You have more control with individual stocks and you can invest in businesses you understand. On the other hand, you have no say in the composition of the indexes tracked by ETFs. With individual stocks, you can research the business fundamentals, earnings history and expectations for upcoming quarters before making an investment decision.
It would be difficult to monitor ETFs the same way, because they usually track indexes with dozens of companies. Therefore, the performance of your investment portfolio would depend on circumstances beyond your control.
Assessing Levels of Flexibility
Individual stocks offer more flexibility because you can pick and choose the stocks that fit your financial objectives and tolerance for risk. For example, you could implement a diversified investment portfolio with dividend-paying stocks, growth stocks and stocks of foreign companies.
ETFs require an indirect investment in all the stocks of particular indexes, which could lead to over-diversification and duplication. For example, ETFs that track the S&P 500 index and the technology industry would have several stocks in common.
Understanding Investment Predictability
The return on investment for an individual stock depends mostly on its fundamentals. You can reasonably estimate its long-term return based on certain assumptions about industry and economic conditions. It is more difficult to predict ETF returns because they could depend on the performance of stocks in different industry sectors.
For example, if the Dow Jones Industrial Average is down 10 percent, the corresponding ETF will also be down about 10 percent regardless of the performance of individual stocks within the Dow. The index could be down because of the underperformance of a handful of stocks or weakness in one particular industry. There is no opportunity to pick undervalued stocks and wait for the market price to catch up to earnings growth, cash flow and other financial fundamentals.
Comparing the Costs
The cost of owning individual stocks is usually less than owning ETFs or mutual funds. You would pay a one-time commission for buying individual stocks, unless you are trying to time the market and trading more frequently. You would pay similar commissions for buying and selling ETFs. You would also be responsible for management fees and expenses.
For example, if the Dow Jones is up 5 percent for the year, the corresponding ETF could be up about 4.75 percent because of a management fee of 0.25 percent. Although these management fees are not as high as actively managed mutual funds, they do affect your return on investment.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.