Stocks vs ETFs: which ones to keep in your portfolio?
Making this choice is no different than any other investment decision. As always, you want to look for ways to reduce the risk. And, of course, you want to generate a return that beats the market.
Reduce volatility of an investment is the general method of mitigating risk. Most investors forgo upside potential to prevent a potentially catastrophic loss. An investment that offers diversification within an industry group should reduce portfolio volatility. This is one way that diversification through ETFs works in your favor.
Improving Jensen's Alpha (a poorly understood and "focused" goal)
Alpha is the ability of an investment to outperform its benchmark. Whenever you can create a more stable alpha, you will be able to experience a greater return on your investment. There is a general belief that you need to own stocks, rather than an ETF, to beat the market. Furthermore, many investors are under the impression that if you buy an ETF, you are stuck receiving the average return in the industry. Neither of these hypotheses is necessarily true because it depends on the characteristics of the sector. Being in the right industry can lead to alpha optimization as well.
KEY POINTS
- Stock selection offers an advantage over exchange traded funds (ETFs) when there is a large spread of returns from the average.
- Exchange traded funds (ETFs) on the other hand can be beneficial if you are unable to gain an advantage through knowledge of the individual company.
Based on your research and experience, perhaps you have a good idea of how well a company is performing. This insight gives you an advantage that you can use to reduce risk and get a better return. Good research can create value-added investment opportunities, rewarding the equity investor.
The retail sector lends itself to Stock Picking
The retail sector is a group where stock picking could offer better opportunities than buying an ETF that covers the sector. Companies in the industry tend to have a wide spread of returns based on the particular products they carry. This can create an opportunity for the discerning stock picker to do well.
For example, let's say you recently noticed that your daughter and her friends prefer a particular retailer. Upon further research, it turns out that the company has upgraded its stores and hired new product management staff. This has led to the recent launch of new products that have caught the attention of your daughter's age group. So far, the market hasn't noticed. This type of perspective (and your research) could give you an edge in stock picking over buying a retail ETF.
The vision of business through a legal or sociological perspective can provide investment opportunities that are not immediately captured in market prices. When such a context is determined for a particular sector - and where there is a lot of yield dispersion - investments in single stocks can provide a higher return than a diversified approach.
For these sectors, the overall performance is quite similar to the performance of any stock. The utilities and basic consumer goods industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector in general, rather than choosing specific stocks. Because the dispersion of returns on utilities and basic consumer goods tends to be limited, choosing a security does not offer a sufficiently higher return for the risk inherent in owning individual securities. As ETFs go through the dividends paid by the industry stocks, investors also receive this benefit.
Consider ETFs When Performance Drivers Are Unclear
Often, stocks in a particular sector are prone to dispersed returns. However, investors (or the consultancy firm you are targeting) are unable to consistently (or sufficiently outperform) select those stocks that are likely to continue to outperform. Therefore, they cannot find a way to reduce risk and improve their potential returns by choosing one or more stocks in the sector.
If the company's performance drivers are harder to understand, you may want to consider the ETF. These companies may have complicated technologies or processesthat make them underperform or do well. Perhaps performance depends on the successful development and sale of a new, unproven technology. The spread of returns is large and the odds of finding a winner can be quite low.
Industries where ETFs are generally a better option
The biotech industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet the expectations in the series of studies (FDA in America, AIFA in Italy) the company faces a gloomy future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.
Some commodities and specialist technology groups , such as semiconductors , fall into the category where ETFs may be the preferred alternative. For example, if you feel that now is a good time to invest in the mining sector, you may want to gain industry-specific exposure.
However, let's assume you are concerned that some stocks may encounter political problems that could hamper their production. In this case, it is advisable to buy in the sector, rather than a specific stock, as it reduces the risk. You can still benefit from growth in the overall industry, especially if it outstrips the overall market.
IN CONCLUSION
ETFs offer advantages over stocks in two situations. First, when the performance of stocks in the sector has a narrow dispersion around the average, an ETF may be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best bet.
While the temptation to speculate with leveraged ETFs (or even CFDs) may be strong, it should be clear that they are not meant to be part of a long-term diversified portfolio. If you have a consultant and he puts one of these into your account, you should consider finding another consultant.
If you have included one in an individually managed account or purchased them for your brokerage account, remember that you can take a high risk with your savings (in which case the use of "contained" levers is always advisable ).
You can and will likely lose a significant amount of money if you keep a leveraged ETF. This is because they are designed to be traded in short time frames, such as a trading day. There are leveraged ETFs designed for longer terms, like a month, but that doesn't reduce the risk you take.
Furthermore, the payoff may not be as high as you imagine , both due to the adverse "compouding" effect on your portfolio return, and due to poor "timing" in the purchase or sale: like any financial instrument (and especially for leveraged ones) Buying after a "dip" offers more opportunities to rise and selling while you are profitable may be a better option than waiting for the first dips.