Modern investing offers lots of options, providing a ready-made solution to nearly every investment quandary. It’s almost enough to make you nostalgic for the days when you just invested in a stock. Almost.
That option still exists and ETFs provide a way to build a position in a sector while still buying individual stocks.
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What is a Stock?
Companies are owned by someone; either by one person, family, by another company, many people, or organizations. In all cases, the company ownership is divided into shares, pieces of the company known as stock. When you own stock, you own shares, a claim on the company’s earnings and assets, but not the corporation itself.
This structure is good for investors (and companies) because it keeps investors legally separate from the company, preventing either party from liquidating the other party’s assets to remain solvent or for any other reason. With a publicly-held company, shares are traded on exchanges, allowing investors to easily enter or exit positions or to build a long-term position with a single stock or a portfolio of stocks.
Check out the SEC’s guide on stock trading basics if you’d like to know more. Stocks are shares issued to raise capital to fund business operations, money in exchange for a claim on future earnings. They can also serve as an exit strategy for early investors in publicly-traded companies, company founders, management, and others in the company who have stock or stock options. Selling these shares in the market is a way to recoup an investment and lock in returns.
What is an ETF?
An exchange-traded fund (ETF) is an investment fund that trades on a stock exchange along with stocks for individual companies. ETFs are flexible investment vehicles which purchase various types of assets to meet their investment goals.
They can track an index like the S&P 500, track a sector, represent a commodity (like gold, oil, or wheat) or sample a basket of stocks or bonds that meet a given criteria. ETFs exist for nearly any investment strategy you can imagine, and if someone imagines something new that can have value, an ETF is sure to follow. The SEC’s guide on trading ETFs and mutual funds is especially useful if you’d like to know more.
ETFs are often similar to index funds, focused mutual funds that track an index.
But, have some key differences from index funds, primarily the way in which they trade, their fees and the way dividends are distributed. ETFs that hold dividend-producing securities distribute their dividends on a quarterly basis. ETFs hold the underlying assets, usually stocks, and investors buy shares of the fund, much like mutual funds — but ETFs are easier to trade because they can be traded through an online broker and don’t require a full-service broker or buying directly from the mutual fund company.
Similarities Between Stocks and ETFs
1. Stocks and ETFs trade on major exchanges
When we think of investing, we often think of stocks or mutual funds. ETFs provide some of the benefits of mutual funds, including diversification, but are traded on a stock exchange like the NYSE or NASDAQ alongside stocks.
This makes ETFs widely available and provides a way for traders or investors to exit positions quickly, much like with stocks. Also like stocks, thinly-traded shares may require some planning and patience if you want to buy or sell because there can be a large spread between bid and ask prices. This isn’t an issue with actively traded stocks and ETFs shares.
2. Stocks and ETFs settle at the same price
Both stocks and ETFs settle at the price at the time of the purchase or sale. Experienced investors know the price of an equity can change by the second, the minute, or the hour — especially if there is news moving the price. Owners of mutual fund shares are along for the ride, whether up or down, because the price of the trade settles at the end of the trading day after the fund rebalances. Stock and ETF trades settle at the executed trade price, which may be higher or lower than the end of day price, but which won’t be a surprise.
Differences Between Stocks and ETFs
The differences between stocks and ETFs go beyond the obvious, which is that ETFs are made up of more than one holding. The differences that affect your portfolio performance revolve around diversification and focus of the investment.
1. The number of shares changes
Stocks have a fixed number of shares. Stock buybacks, stock splits, and secondary offerings all change the number of shares for a stock — but these events don’t happen all day, every day. ETFs, by comparison, create and redeem shares as needed to more closely match the share price to the Net Asset Value, or NAV, a measure of the fund’s total assets minus its liabilities relative to the number of shares outstanding.
This creation/redemption mechanism adjusts the number of shares in the ETF and helps the ETF more effectively track the performance of the index or asset class it attempts to mimic.
2. ETFs can be focused or diversified
Individual stocks are a direct bet on a company’s future earnings, or more accurately, its stock price. The two don’t move in tandem. ETFs, however, can be either focused, holding only a few securities or assets, or diversified, representing a large index, like the S&P 500, which features companies in every major sector. More focused ETFs can have similar performance to individual stocks because they have such a limited core of holdings.
This can be great news or bad news — or somewhere in between — but it does provide investors with a way to trade on investment strategies that would be difficult to duplicate with a basket of individual stocks.
Individual stock investing has been around for over 400 years, while ETFs have yet to turn 30. The upstart funds are here to stay for the foreseeable future and the number of ETFs seems to grow daily, proving their utility as a focused investment vehicle or as an index investing product. Quietly, a number of ETFs also disappear each year because they can’t attract enough investment interest.
Individual stocks can disappear as well, and often not as gracefully as an ETF. A well-diversified portfolio probably has some room for individual stock investing or investing in specialized ETFs without putting the greater portfolio at risk — and part of the fun in investing is taking a measured risk, a bet that you’re right about the future price.
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