Choosing Between Stocks and ETFs for Sector Investment
When you decide to invest in a specific sector, you often choose between buying individual stocks or opting for an exchange-traded fund (ETF). As with any investment decision, reducing risk while aiming for a market-beating return is critical.
Mitigating risk often involves reducing an investment’s volatility. Most investors are willing to sacrifice some upside potential to avoid significant losses. By providing diversification within an industry, ETFs help lower your portfolio’s overall volatility, which is why they can be a favourable option.
Key Takeaways
- When deciding between investing in individual stocks or an ETF within a sector, it is essential to evaluate how to minimize risk while still aiming for market-beating returns.
- Stock-picking can outperform ETFs when there is a broad variance in returns within the sector.
- ETFs provide advantages when sector stock returns show a narrow range around the average.
- ETFs may be better if you lack in-depth knowledge of the companies involved.
Striving for Alpha
Alpha refers to an investment’s ability to outperform its benchmark. Many believe that achieving alpha requires stock ownership rather than an ETF. Similarly, there’s a common misconception that investing in ETFs means settling for average returns. Neither assumption is accurate; it depends on the sector’s characteristics.
In some sectors, being correctly positioned can still help you achieve alpha, even with an ETF.
When Stock Picking Makes Sense
In sectors with a significant spread of returns or where fundamental analysis can uncover mispriced stocks, stock-picking offers the chance to beat expectations.
If your research or experience gives insights into a company’s performance, you could leverage that information to lower risk and potentially increase returns. Good stock research can reveal valuable investment opportunities, rewarding stock pickers with superior returns.
The Retail Sector is Ideal for Stock-Picking
The retail industry is one sector where stock picking often outperforms an ETF. The diverse range of returns between companies in this sector depends mainly on the products they carry. This diversity offers stock pickers a chance to capitalize on undervalued opportunities.
For instance, imagine you’ve noticed your daughter and her friends showing a preference for a particular retailer. Upon investigation, you find that the company recently upgraded its stores and hired new management, leading to a popular product launch. If the market hasn’t recognized this change, your research might provide an advantage over buying a retail ETF.
Insight into a company’s market or legal environment can create stock-picking opportunities that might not be reflected in market prices. Individual stock investments can outperform a diversified approach in sectors where returns are widely dispersed.
When an ETF is the Best Option
In sectors where stock returns show limited variation from the average, stock picking offers a slight advantage in generating market-beating returns. These sectors tend to have similar performance across companies, making ETFs a more viable option.
Performance across companies in sectors like utilities and consumer staples is relatively uniform. As a result, stock-picking doesn’t offer significantly higher returns than owning an ETF. Additionally, ETFs pass on any dividends paid by the underlying stocks to investors.
Consider ETFs When Performance Drivers Are Unclear
Identifying which stocks will continue to perform well can be difficult in sectors with wide return dispersion. If an industry’s key performance drivers are challenging to understand, an ETF might be the safer bet.
For example, some companies rely on complex technologies or processes, and their success may hinge on uncertain future developments. In such cases, the odds of finding a winner among the companies may be low, making an ETF a more secure choice.
Industries Where ETFs Are a Stronger Option
The biotechnology industry is an example of where ETFs can be a better option. Many biotech companies rely on successfully developing and selling a new drug. If the drug fails in clinical trials or the FDA denies approval, the company’s outlook can be grim. Conversely, if the FDA approves the drug, the rewards for investors can be substantial.
Certain commodities and specialized technology sectors, such as semiconductors, also fall into the category where ETFs might be preferable. For instance, buying an ETF can reduce your risk while benefiting from sector-wide growth if you’re bullish on the mining sector but concerned about potential political risks impacting specific companies.
In January 2024, the SEC approved the first spot market Bitcoin ETFs. Trading cryptocurrencies through an ETF offers a more straightforward route than traditional methods like using crypto exchanges, managing storage wallets, and safeguarding private keys. ETFs are especially useful for investors unfamiliar with the intricacies of crypto markets but still want exposure to this emerging asset class.
Downsides of ETFs
While ETFs make investing easier across a broad range of stocks, they have certain downsides. Though they are generally low, these include the fees associated with managing the ETF. Another risk is that the ETF could deviate from the benchmark it’s designed to track. There’s also the issue of concentration risk, as ETFs often focus on a single sector. Lastly, investors don’t have control over the individual stocks held within the ETF, which might not appeal to those aiming to beat the index, as that’s not the primary goal of an ETF.
Do ETFs Pay Dividends?
Yes, ETFs pay dividends for the stocks within the fund that distribute them. If a stock in the ETF doesn’t pay dividends, ETF investors won’t receive any dividends from that stock. If a stock does pay dividends, the ETF is legally obligated to pass them on to its investors.
Do You Own Shares in an ETF?
When you invest in an ETF, you don’t own the underlying stocks or assets. Instead, you own shares of the ETF itself. For instance, if the ETF holds Apple stock, you don’t own any direct shares in Apple—your investment is solely in the ETF.
Final Thoughts
When choosing between individual stocks and ETFs, weigh the risk against the potential return. Stock-picking can be advantageous when there’s a wide variance in returns within a sector. With stock picking, your knowledge of the industry or company gives you an edge.
On the other hand, ETFs shine in two scenarios. First, they are beneficial when the stock returns in a sector cluster closely around the mean. Second, an ETF is likely the safer choice if you don’t have specialized knowledge of the companies.
Whether you invest in stocks or ETFs, staying informed about the sector or individual companies is essential. Keeping up with the underlying investment fundamentals ensures that your efforts to pick the right stock or ETF are well-spent. Additionally, take the time to research and select the broker that best suits your investing needs.
Discussion about this post