Understanding the similarities and differences between stocks and exchange-traded funds (ETFs), can help investors decide how to use these securities in their portfolios. So, what are ETFs and stocks?
A stock represents partial ownership in a company. An investor who owns one or more shares may receive benefits such as dividends and can vote on electing directors who oversee the company’s management. An ETF, on the other hand, is a type of professionally managed investment. They're made of a collection of assets such as stocks, commodities, and bonds. When an investor buys an ETF share, they own a fraction of that pool of investments.
Similarities between ETFs and stocks
- Trading. Investors can buy and sell stocks and ETFs throughout the trading day on stock exchanges, making them widely available. They're typically found in brokerage accounts and other vehicles such as 401(k)s and IRAs.
- Purchase price. ETFs and stocks are bought and sold at the price they appear to be at the time of the trade, providing transparency.
- Transaction costs. An investor who buys and sells stocks and ETFs may pay commission fees. Many brokerages, however, offer fee-free trades.
- Liquidity. Stocks and ETFs generally have the same level of liquidity, meaning an investor can rapidly convert shares into cash. It does depend on the quality of the individual asset, however. Selling shares is generally easier with high-quality stocks and ETFs, while lower-quality securities may take longer to unload.
- Tax implications. Investors must pay taxes on dividends and/or capital gains they receive for both stocks and ETFs. Dividends are a portion of a company's earnings that are paid to shareholders, while capital gains represent income an investor makes when they make a profit when they sell their shares.
- Fractional investing. A fractional share is an investment that's less than a full share, usually of an expensive security. Many brokerages offer fractional shares for stocks and ETFs, so an investment in either of these can be a dollar amount instead of a full share or a number of shares.
- Potential dividends. Companies may periodically pay dividends to stockholders. Similarly, an ETF that receives dividends from the stocks it holds can pass them on to its shareholders.
Differences between ETFs and stocks
- Composition. A stock is an investment in a single company while an ETF is a basket of securities. This can contain stocks, but they also may include bonds, currencies, and commodities.
- Risk. Stocks may be higher-risk because they're tied to the performance of one business. If something goes wrong at the company, stock prices are open to volatility. Because ETFs are more diversified, they're generally less volatile, unless they follow a particularly volatile sector.
- Income stream. Both types of investments can provide income but in different ways. Some stocks pay out dividends on a regular basis. ETFs may pay dividends from stocks, either with cash or additional shares of the ETF, or interest payments from bonds.
Potential benefits and risks of buying ETFs
A key benefit of exchange-traded funds is that a single security gives broad exposure to multiple companies, industries, or investing styles. There are different types of ETFs, so investors can choose funds that are more focused if they're interested in a particular market segment; or, investors can invest in index funds, which track specific stock indexes, like the S&P 500. This diversity may reduce an investor’s risk. ETFs can also be easily traded, may have lower fees than other types of securities, and may incur lower tax bills.
However, there are some drawbacks of investing in ETFs. Investors have less control over these securities because a fund manager selects the assets in the fund. And they're usually designed to track an underlying asset—not beat it—so the ETF often won't outperform the securities within the index.
ETFs may also stray from their intended benchmarks from time to time. For instance, the fund manager may swap out assets in the fund—and because the holdings no longer align, the performance of the fund may deviate from the performance of the index, something known as tracking error.
And while ETFs often are cheaper than some other types of securities, they aren't free, and they may come with a management fee. The ETF’s "expense ratio," is the percentage of an individual’s investment paid to the ETF each year. The expense ratio subtracts from an investor’s total returns, even on passively managed funds. ETF costs may amount to a few dollars, but they add up and can reduce investment performance over time.
Finally, not all ETFs offer broad diversification. Some are narrowly focused on a particular sector of the market or a subset of an asset class, which provides less diversification for the investor. For instance, an ETF may focus on a particular commodity, industry, or market cap.
Potential benefits and risks of buying stocks
When trading stocks, investors can do their own research and direct their money toward companies they believe in. This allows investors to customize their portfolios and make decisions based on where they want to see the company headed. High-quality stocks may also provide reliable income if they pay dividends.
Of course, some investors find that researching and hand-picking stocks is too time-consuming or difficult. Without much experience and knowledge, it can be difficult to choose stocks that yield consistent returns. Investing in this type of security may also be nerve-wracking because the stock market always rises and falls, sometimes by a lot. A person could lose much of their investment if a company does poorly and it goes broke, common shareholders could lose their entire investment.
The bottom line
ETFs and stocks give investors the opportunity to earn returns in financial markets. But a stock represents an ownership stake in a single business, whose fortunes may vary widely, while ETFs offer more diversification and therefore may not be as volatile.