ETFs vs. Individual Stocks

ETFs vs. Individual Stocks

It’s important for investors to understand the key differences between individual stocks and exchange-traded funds (ETFs). Each has its advantages and disadvantages. This knowledge can translate into making informed investment decisions. Let’s focus on the key points.

Diversification

Diversification is an attractive feature of ETFs. Instead of taking concentrated risks by purchasing individual stocks, investors can own an index of stocks with ETFs. Owning individual stocks has special risks and often requires diligent attention.

In addition to reducing market volatility, many investors have cut their commitment to time consuming and expensive stock research. By over and underweighting ETF industry sectors, for example, investors can obtain an optimal allocation that suits their financial goals.

INDIVIDUAL STOCKS VS. ETFs
Individual Stocks
Exchange-Traded Funds
Continuous trading and pricing throughout the day?
YES YES
Can be bought on margin?
YES YES
Can buy/sell options?
YES YES
Can be shorted on a downtick?
YES YES
Can be purchased through a traditional or online broker?
YES YES
Can use in an IRA, 401(k), or another retirement plan?
YES (1) YES (1)
Traded on what exchanges?
Amex, NYSE Arca, NASDAQ Amex, NYSE Arca, NASDAQ

Leverage

Like individual stocks, ETFs can be leveraged with margin. Margin is borrowing money from a broker to buy securities and involves considerable risk. Minimum maintenance requirements are enforced by the NASD (National Association of Securities Dealers), the NYSE and by individual brokerage firms. While margin investing can be profitable for investors correct about the direction of their holdings, the interest charges or borrowing costs can deteriorate returns.

There are a multiplicity of option strategies with both stocks and ETFs. Purchasing call or put options is an aggressive technique. An options investor can control a large amount of ETF shares by paying a premium. The premium price is a fraction of what it would cost to purchase the shares in the open market. This provides an options investor with a great deal of leverage and a high risk/reward opportunity.

A more defensive approach uses put options in conjunction with portfolio holdings. Buying protective puts on ETF or stock positions would insure a portfolio against declining prices. There are many other tactical possibilities with options.

Shorting

ETFs, like individual stocks, can be shorted. Shorting involves selling borrowed shares an investor does not own in expectation the price of an ETF will decline in value. If the ETF does decrease in value, it can be bought by the short seller at a lower price, which results in a profit. In 2007, the Securities Exchange Commission (SEC) decided to allow shorting individual stocks on a downtick. Shorting is an advanced technique and involves substantial risk.

Tax Loss Harvesting

Wash-sale rules don’t permit investors to realize a stock loss if they repurchase the same stock within 30 days. This problem can be avoided with smart tax loss planning. By redeploying the loss proceeds into an ETF in the same sector as the stock, for example, the wash-sale rule can be avoided. This allows investors to offset any capital gains with capital losses and still maintain market exposure.

(1) For employer sponsored retirement plans, stocks of other companies and ETFs may not be available as an investment option. Self-directed retirement plans may offer a broader menu of investment choices which may include stocks and ETFs.

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