If you’re new to investing, you may be wondering what you should be investing in. There are so many complicated terms that are thrown around in the investing world and it can be quite confusing for a beginner. If you've ever browsed personal finance blogs or forums, you'd most certainly have come across posts/articles mentioning stocks and ETFs (Exchange Traded Funds). But what exactly are they? And which one should you consider buying when building your own investment portfolio?
In this article, we go over everything you need to understand about stocks and ETFs. We’ll cover what they are, the differences between them, and what you should know before you invest in them.
What are stocks?
A stock is a type of security that represents the ownership of a portion of a company. Stocks are sometimes referred to as equities and are traded in units called shares. For example you’d say “I bought 3 shares of ABC company’s stock”. However, in practice, you’ll often see the words stock and share used interchangeably.
Companies sell shares to raise money to fund their growth and operations. In exchange, the owner of a share (called the shareholder), is entitled to vote in shareholder meetings, receive a portion of the company’s profit (i.e. dividends), and sell their share to somebody else.
There are two types of stock: common and preferred. Common stock usually gives the right to vote at shareholders' meetings and receive any dividends, while preferred stockholders generally do not have voting rights, though they get preference on assets and earnings. Individual investors generally do not hold preferred stocks because of limited availability and lower potential returns.
What are ETFs?
An ETF is another type of security that groups multiple assets as one unit. ETFs are structured to track indices (e.g. S&P 500), sectors (e.g Tech sector - think Facebook, Apple, Amazon, Google, and more as one entire ETF), commodities (e.g precious metals like gold) or other types of assets. They can be composed of stocks, bonds, commodities, or even other ETFs. The assets that make up an ETF are called holdings or underlying assets.
One thing to note about ETFs is that when you own a unit of an ETF, you do not directly own the underlying assets that compose it, the fund manager does. This means that you cannot vote in shareholders' meetings, receive dividends from each asset in the ETF, or sell the shares of the underlying assets. However, since you own the unit of the ETF, you are able to sell it, and most ETFs distribute income (e.g. dividends) to the end investor.
ETFs are managed funds and are associated with a fee, called MER, that compensates the fund manager for operating the fund. These fees are usually low and represent less than 0.2% of the value the investor holds in the fund.
As their name suggests, ETFs are traded on exchanges, as opposed to mutual funds, which are traded once a day after market close. This difference is important because it means that ETFs’ prices change throughout the day as they are bought and sold.
What are the similarities between stocks and ETFs?
Before we get to the differences between stocks and ETFs, let’s look at what they have in common.
The first similarity between stocks and ETFs is that both are traded on exchanges. Individual investors can buy and sell stocks and ETFs at a brokerage. That also means that the share price of both stocks and ETFs fluctuates throughout the day.
Another similarity is that, for both stocks and ETFs, investors get returns from appreciation in value and through distribution (e.g. dividends).
The first return you can expect from a stock or ETF is an appreciation of price. When you make an investment, you generally expect that the price of your purchase will increase. Investors make a return on the difference between the price they bought at, and the price they sold it at. For example, if you buy a share of a stock (or ETF) at $100 and sell it at $125, you made a $25 or 25% return.
The second type of return that investors can expect from both stocks and ETFs is distribution payouts. For stocks, these distributions are called dividends and they are a share of the profit distributed by the company to its shareholders. For ETFs, it depends on the composition of the ETF or its holdings. For example, ETFs composed exclusively of stocks also distribute dividends, but an ETF that tracks bonds will distribute coupons.
Not all stocks or ETFs have distributions, but most established corporations or ETFs that track them do. Distributions are often made quarterly, although there is no rule. Some are paid monthly, semi-annually, annually, or even at irregular intervals.
Look for the term dividend or distribution yield in the ETF factsheet. It is the ratio of yearly distribution to price. For example, if a unit costs $100 and the distribution is $5 per unit annually, the distribution yield is 5%. This is an indication of how much you can expect from owning the unit in a given year. Given how it’s calculated, an increasing distribution yield can relate to an increasing distribution payment and/or to a drop in price, so it’s important to look at the full picture and not just that metric when choosing a distribution-focused investment.
What are the differences between stocks and ETFs?
Now that we covered the similarities, let’s dive in the differences that can make an investor decide to buy a stock or an ETF.
One of the main differences between stocks and ETFs is diversification. Since an ETF is a basket of assets, it’s already diversified on its own. However, be mindful that it depends on the ETF. There are varying degrees of diversification with ETFs. An industry ETF, especially if the industry has a limited number of players, has limited diversification compared to a broad-market ETF, or even an all-in-one ETF.
The industry ETF can be almost as risky as buying a stock in the industry, while a broad-market ETF would generally give you decent diversification, even if you bought nothing else. All-in-one ETFs, such as XGRO or XBAL, are baskets of ETFs that are meant to represent an entire portfolio in one unique asset. They usually consist of both stocks and bonds and mostly provide geographical and sector diversification.
The other side of the diversification coin is that ETFs don’t allow for customization. While there are a variety of ETFs that appeal to most investors, it’s either all or nothing when it comes to investing in ETFs, and you cannot exclude stocks that you don’t like from the fund. When you invest in stocks, you can cherry-pick the companies that you like based on any criteria you want: best performance, high/increasing dividends, socially responsible, etc.
The other difference is ownership. ETFs don’t provide ownership of their underlying assets. For a lot of investors, it’s not a big issue because voting rights don’t really matter to them, and they get enough dividends from the ownership of the ETF. However, some investors prefer holding individual stocks for this reason.
What about the cost? ETFs come with MER, so there’s an additional cost you wouldn’t be charged when buying stocks. However, this is the cost for a more accessible, easier investment product. Let’s look at an example. If you wanted to invest in the S&P 500, you could buy an ETF that tracks it, such as VOO, or you could buy the stocks that make the S&P 500. A share of VOO is (at time of writing) trading at close to $390USD. To buy a share of each stock in the S&P 500, you would need to spend thousands of dollars. You would also have to update your portfolio regularly as the S&P 500 changes over time, while with an ETF, it would be done for you by the fund manager.
The bottom line
Stocks and ETFs are two types of securities that both have their place in a diversified portfolio. ETFs are often seen as safer because they offer built-in diversification, but stocks allow for more customization, as well as direct ownership rights that ETFs don’t.