One common feature of an exchange-traded fund (ETF) and an individual stock is that investors can trade both freely through an exchange. While both investment vehicles share this similarity, they also have their differences.
Both have their place in an investor’s portfolio, but below are five reasons to pick an ETF over a stock.
1. Diversification Benefits
Like stocks are shares or fractional ownership of a company, the ETF owns underlying assets and divides ownership of those assets into shares. As such, these shares can be bought and sold on a major exchange.
Furthermore, as opposed to ownership of a company, ETFs own the actual stocks themselves. As such, ownership of an ETF offers diversification advantages compared to single stocks.
Stocks are exposed to all of the risk associated with ownership of that particular company. Conversely, an ETF that purchases a mix of stocks or other assets will have less risk exposure.
As stated, because of this flexibility, they can be traded intraday. This allows investors to trade them through online or traditional brokers just like stocks.
An ETF shareholder is also entitled to income earned through dividends. In the event the fund is liquidated, ETF shareholders may also receive a portion of its residual value, which is the value determined at the end of an asset’s useful life.
2. Sector Exposure
Investors who want to obtain a concentration in a certain sector would have to buy individual stocks that comprise that sector. However, with a single ETF, an investor can gain sector exposure since the fund contains a basket of shares containing various stocks as opposed to a single stock.
For example, an investor who wants to gain exposure to semiconductors in general would need to build a portfolio that may contain the leaders in that particular industry. Furthermore, an investor may just want exposure to medium-sized and foreign semiconductor companies.
This type of investor focus would require purchasing individual stocks to meet that criteria. On the other hand, a semiconductor ETF like the VanEck Vectors Semiconductor ETF (SMH) will give the investor the exposure he or she is seeking.
3. Possibly Lower Costs
Because an ETF can track an index, it can be passively-managed. This translates to lower costs to investors when compared to mutual funds, which are typically actively-managed.
Actively-managed mutual funds carry greater operating costs because they have to pay analysts and other research specialists. The lower costs of ETFs show in their expense ratio, which is the cost to run the fund.
Since stocks themselves don’t represent shares of a fund, there are not expense ratios attached to them. If an investor is building a portfolio of a sector with stocks, the costs can add up in broker fees.
ETFs, on the other hand, can allow an investor to gain exposure to a specific sector with one purchase as opposed to buying individual stocks.
4. Inverse and Leveraged Options
If an investor is betting that a specific sector or stock will go down, he or she will have to short that stock or group of stocks. Furthermore, shorting stocks are typically bought on margin, meaning the investor will have to borrow the money from the broker–known as leverage.
With an inverse ETF, an investor can be bearish without having to buy the securities on margin. If an investor does wish to leverage a trade, there are leveraged ETFs available that allow investors to amplify their returns by multiples of two or three, depending on the ETF product.
5. Access to Other Asset Classes
An investor who wishes to invest in fixed income must purchase bonds. If an investor wants to allocate capital into physical gold, he or she must buy the precious metal and store it.
An ETF can allow an investors to access the bond market without actually purchasing the debt and the commodities market without purchasing actual gold. This is because an ETF is a type of security that tracks an index, bonds, commodities, currencies, or a mix of various asset classes.
For more educational information on ETFs, click here for Education Central.