What Is an ETF?
An exchange traded fund (ETF) is a basket of individual securities that can be bought and sold in a single trade on a stock exchange. The individual securities within an ETF can be stocks, bonds, currencies, commodities, or other investments.
When you buy shares of an ETF, you own a fraction of the underlying pool of investments, much like you do when buying shares of a mutual fund. The net asset value (NAV) of an ETF represents the per-share value of the fund’s assets less any liabilities.
ETFs have grown exponentially since 1993 when State Street Global Advisors launched the first US-listed ETF. Today, investors can choose from thousands of ETFs to meet their individual portfolio needs, from gaining broad market exposure and generating income to accessing difficult-to-reach markets.
What Is a Stock?
A stock is a security that represents fractional ownership of the specific issuing company. Publicly traded stocks trade on stock market exchanges, like the New York Stock Exchange or Nasdaq.
ETF vs. Stocks: Similarities
Transparency
The holdings of most ETFs are fully transparent and available daily. This means investors know what they own at any moment, allowing them to make more informed investment decisions with greater accuracy. Similarly, when investors hold individual stocks, they know what they own.
Broad Range of Investment Options
Both ETFs and stocks can be used to gain exposure to a variety of market segments, covering different geographic locations, market capitalizations, styles, sectors, and industries.
Transaction Fee or Commission
Because ETFs and individual stocks are bought and sold on an exchange, they are both generally subject to a transaction fee or commission. Note that some online brokers offer commission-free trading of stocks and ETFs.
Pricing and Trading
Investors can buy and sell ETF shares and individual stocks on an exchange continuously throughout the trading day. Because stocks and ETFs trade throughout the day on an exchange, they offer favorable liquidity and allow investors to make timely investment decisions and quickly execute based on shifting market conditions.
Exchange trading also means the trading prices of both ETFs and stocks represent the current market price. With an ETF, the share price may be slightly more or less than the net asset value (NAV).
Exchange trading also means investors can employ a wide range of trading techniques — from buying on margin to placing limit orders.
Dividends
Many companies periodically pay out a portion of their profits to shareholders in the form of dividends. Similarly, ETFs may receive dividends from stocks they hold, which are in turn paid to investors who own shares of the ETF.
ETFs vs. Stocks: Differences
Diversification
Passive, or index, ETFs generally track and aim to outperform a benchmark index. They provide access to many companies or investments in one trade, whereas individual stocks provide exposure to a single firm. As such, ETFs remove single-stock risk, or the risk inherent in being exposed to just one company.
The diversification of index funds across many securities can dilute the potential negative impact of poor performance of any one security.
Research and Management
ETFs are professionally managed funds backed by a team of experts working to meet the goals outlined in the fund’s prospectus. Fund managers are tasked with researching, buying, and selling individual holdings in return for a fee.
Expense Ratio
ETFs have an expense ratio, which includes management fees and the fund’s total annual operating expenses.
Capital Gains Distributions
Turnover in an ETF’s holdings — due, for example, to changes in an ETF’s underlying index — could trigger the sale of securities. This may trigger transaction costs and capital gains distributions. In this scenario, any realized gains or losses are passed on to ETF shareholders. To ensure tax efficiency, ETF managers attempt to limit these types of transactions as much as possible. ETFs’ tax-efficient in-kind redemption process used to meet shareholder redemptions limits capital gains distributions.
Are ETFs or Stocks Right for You?
When choosing whether to add individual stocks or ETFs to a portfolio, it’s important to consider your risk tolerance and overall investment objectives. In many instances, ETFs provide a solid foundation for a diversified investing strategy, offering an easy way to gain exposure to a breadth of asset classes, sectors, and regions.
For their part, individual stocks allow investors to express specific bets on companies, but their lack of diversification may increase overall portfolio risk. Ultimately, the optimal portfolio may contain a blend of stocks, ETFs, and other investment products.
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