Stocks or ETFs?

Want to get in on the action? Start here.

Andrew Willis 30 March, 2020 | 1:18AM
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Editor's note: Read the latest on how the coronavirus is rattling the markets and what you can do to navigate it.

Stocks markets have been abuzz around COVID-19 as selling (and buying) out of fear (and fear-of-missing-out) reaches fever pitch. If you’ve been on the sidelines until now, and want to make a play of your own, or even if you are invested and want to add to your portfolio, what are the options?

To start, you have the choice of a single company (stock) or a mixed bag (ETF). Which you choose depends on how involved you want to be, how much you want to pay to invest, and how you keep your portfolio diversified. Let’s start with stocks.

Stocks: Advantages
“From the portfolio management perspective, holding individual stocks in your portfolio allows a great deal of control over your investment decisions,” says Ian Tam, Director of Investment Research at Morningstar Canada.

That control could be crucial in a country like Canada, where so few industries can take up so much market share, says Jason Heath, Managing Director at Objective Financial Partners. The TSX is heavily biased toward financials and energy stocks – 32% and 16% of the TSX respectively as of February 28, 2020, Heath notes. “[In the U.S.] The S&P 500 has only 12% and 4% in these sectors.”

More control also comes in the form of more information, says Heath, “ETF holdings are disclosed monthly, but you will not have the same visibility on an investment statement as with individual stocks.” With stocks, investors can also control things like the timing of capital gains and losses, and tax planning, Heath says.

“Plus, with stocks, investors who want to actively participate in a company’s growth also get shareholder rights, in particular when voting proxies issues that you feel strongly about,” Tam says.

Stocks: Disadvantages
Access to all this comes with a lot of work. “Assuming that you have a sound investment process in place to ensure a diversified portfolio of stocks, the main disadvantage in holding stocks is maintenance,” says Tam. “Stock prices move quickly, and ensuring you maintain target stock weights within the sleeve of your equity portfolio and also within the context of your overall asset allocation requires disciplined work.”

“A portfolio should have 15-25 stocks at minimum to be properly diversified,” Heath agrees, “Building, let alone monitoring a portfolio takes work and that work has a cost to DIY investors as well as investment advisors.”

And there are costly pitfalls, both operational and psychological, to watch out for if you want to DIY. “Particularly in Canada, liquidity risk can also be an issue. Outside of the largest 60 or 75 names in Canada, investors can expect to see a meaningful bid-ask spread when trading, (meaning you will end up paying more than the last trade price when buying, and getting less than the last trade price when selling, especially in larger quantities),” says Tam, adding that if you want to be in a driver’s seat, you’ll also have to control your mind to be able to sift through today’s 24-hour news cycle without forming a bias.

ETFs: Advantages
ETFs on the other hand, remove much of the control – and temptation – by packaging stocks based on either indexes, computer algorithms or active management direction similar to what you might get in a mutual fund.

For one, the need to do your own diversification is reduced. “Equity ETFs remove the need to re-balance within the equity portfolio as this is done for you automatically to ensure you are exposed to the ETF’s prescribed allocations to each position,” says Tam.

This doesn’t necessarily mean you can do less with ETFs. “Equity ETFs offer scale. A single unit can grant you exposure to hundreds of companies and provides instant diversification,” adds Tam. “Especially for smaller investors, this scale is not something to be overlooked as it is an effective way to gain exposure to a well-diversified portfolio.”

Some sectors are difficult to replicate on your own, especially in foreign markets where Canadians might not have access to individual stocks, adds Heath, allowing you to cross borders and asset types in one purchase. “The introduction of all-in-one ETFs has made it so that investors can buy a single ETF and have diversified exposure to bonds and stocks, including international stocks.”

Also having a hybrid approach where you’re partnering up with a computer or human in your stock picking can mean achieving more. “Actively managed ETFs also enable retail investors to benefit from professional money managers who have the resources and experience to effectively manage your portfolio,” adds Tam.

This all comes at a reasonable price. “ETFs have much lower costs than mutual funds,” says Heath. “Stock ETFs have management expense ratios (MERs) of under 0.1% in many cases, compared to mutual funds, with average costs approaching 2%.”

ETFs: Disadvantages
But the saying “you get what you pay for,” applies to ETFs. Investors in passively-managed ETFs should know that the low-fees mean automation and the potential for errors, especially in subjective and rapidly changing areas like ESG investing.

And then there’s tax. “Canadian listed ETFs that track U.S. stocks are subject to U.S. withholding tax,” notes Heath. “Buying U.S. stocks directly in an RRSP account, or buying U.S.-listed ETFs that track U.S. stocks, can avoid IRS tax withholding.”

But before you can even get to assessing tax implications, you have to navigate an ever-widening array of ETFs on offer, something that can be daunting for DYI investors. “As ETFs have developed, there are now over 750 funds trading on the TSX. If you include U.S. listed ETFs easily accessible to Canadian investors, there are thousands of ETFs to choose from. It can be a lot of work to narrow down the best ETFs for an investor.

Tips and next steps
Both stocks and ETFs can be easily accessed. Discount brokerages also make it relatively inexpensive to trade stocks (in Canada this can drop to as low as $5 per trade), says Tam. And the same goes for ETFs, easily purchased for free (in exchange for a management fee).

On the costs, depending on your target sector, ETFs can be a handy way to invest in a certain sector or country without having to pick individual stocks, let alone incur the cost to buy several individual stocks and get diversification, says Ian Tam. Trading commissions can add up fast.

Whether you’re choosing stocks or ETFs, you’ll want to be aware of home bias. “There is a disproportionate weight on Canadian stocks and bonds in retail portfolios when compared to professional/institutional investors.  As an example, the Canadian Pension Plan Investment Board has just 15% of assets invested in Canada,” Tam says.

Try not to load up too much on Canadian companies in your selection, and don’t be afraid of buying both stocks and ETFs. “ETFs can be a complement to a portfolio of stocks and bonds,” says Heath, while investors building their portfolio only with ETFs ideally have exposure to Canadian, US, and international stocks, as well as bonds. How much in each will still depend on factors such as your risk tolerance, time horizon and tax situation.

Stocks vs ETFs

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Andrew Willis

Andrew Willis  is Content Editor for Morningstar.ca. Follow him on Twitter @AndrewWillisCDN.

 

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