The Trade-offs in Owning Stocks vs. ETFs
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For the last several weeks, I’ve shared my top 10 questions to ask before you buy any stock. As some of you probably thought to yourselves, “Wow! That is a lot of work. And after doing it all, I may not even buy the stock! There has to be an easier way.” If you’re planning on holding 10 stocks, you may think that means if you are super lucky maybe you only have to do this 10 times.
Well, I can quickly tell you that is far from the case. There’s an old expression about kissing many frogs to find a prince. When looking for the right stocks at the right time, that saying holds true. But we also have to remember in this increasingly frenetic world of cable news, Twitter, Snapchat and others that the “buy and hold” investing of yore, which is akin to Crock-Pot cooking ("fix it and forget it," as some books call it), has been replaced with active investing.
Let’s not mix terms: active investing is not “active trading,” but rather being proactive in looking at your investments. Somewhere between frequently and periodically you should review what you own, why you own it and whether or not you should own it or replace it with another stock that may be better positioned with a more favorable risk-to-reward trade-off at that time. Think of it like maintenance on your car -- if you don’t change the oil and other fluids and replace the tires every so many thousands and thousands of miles, at some point it won’t hold up. It will break down and cost you money to fix it.
The same goes with your portfolio. If you “fix it and forget it,” at some point the tailwinds that led to you selecting a particular stock or stocks may change. BlackBerry’s business suffered with the introduction of Apple’s iPhone, as did the music industry first with iTunes and then streaming alternatives.
The bottom line is that owning a portfolio of individual stocks is an ongoing and iterative process that requires you to continue looking for potential candidates among contenders and pretenders so you have a second string waiting in the wings.
Think of baseball or football teams that can have more players than necessary to field a team. A Major League Baseball (MLB) team has 25 players even though just nine take the field during a game as the other team bats. Typically, a 25-man roster will consist of five starting pitchers, seven relief pitchers, two catchers, six infielders and five outfielders.
The same idea applies to investing. For each stock position in your portfolio, whether just a few or more than a dozen, you should have a few contenders that you can call into your holdings to replace an existing one as situations and circumstances warrant.
Now, you’ve probably come to the conclusion that there is more work than asking just 10 “simple” questions. But let’s address a thought that is likely burning even hotter in your brain now:
“Wow! That is a lot of work. And after doing it all, I may not even buy the stock! There has to be an easier way.”
The reality of the situation is that, yes, there are “easier” ways to invest, and one of them is to use exchange-traded funds (ETFs). ETFs have been around for several years and they have continued to gain both market share and mindshare with investors. As the ETF industry has matured, we’ve seen it move beyond index-mimicking offerings such as the SPDR S&P 500 ETF Trust (SPY) that corresponds to the price and yield performance of the S&P 500 Index.
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There also are ETFs for other market indices, as well as those that offer certain baskets of stocks like the Consumer Discretionary SPDR (XLY) that is comprised of companies that benefit from discretionary consumer spending. Such stocks include Amazon.com (AMZN), Walt Disney Company (DIS), Comcast (CMCSA) and Home Depot (HD) in XLY's top holdings vs. those like Procter & Gamble (PG), Coca-Cola (KO), Philip Morris International (PM) and CVS Health (CVS) found in the Consumer Staples Select Sector SPDR ETF (XLP).
There also are geographically focused ETFs, such as iShares Europe (IEV), iShares China Large-Cap (FXI) and others that allow one to invest in the prospects of a particular country or region on the road to economic expansion.
We’ve also started to see the rise of thematically based ETFs. As fingers are put to keyboard, one of the most popular thematic ETFs is PureFunds ISE Cyber Security ETF (HACK), which, as its name implies, holds cybersecurity companies. They include Fortinet (FTNT), Check Point Software (CHKP), Palo Alto Networks (PANW), Proofpoint (PFPT), Imperva (IMPV), Cisco Systems (CSCO), Splunk (SPLK) and others. As I’ve shared with my Growth & Dividend Report subscribers, cybersecurity is a pain point that we will contend with as we continue to migrate deeper into the Connected Society. That puts it squarely in the center of the Safety & Security theme. But what if you don’t have enough time to delve into the more than 30 cybersecurity companies the ETF holds? Simple: you buy the ETF and you get broad-based exposure, which also provides diversification.
Now here’s a trade-off to consider. Such diversity means a pronounced move in the ETF requires that the shares of those cybersecurity companies need to move in the same direction at the same time. Remember, all those companies tend to compete with each other for customers, revenue and market share. That situation means their shares probably won’t all move in the same direction all of the time. That reality will cap your upside more than if you combed through all of HACK’s holdings and narrowed it down to the best-positioned companies at a favorable risk-to-reward trade-off at that point in time.
The flipside of that is if things go wrong for a particular company and its shares, one might see the stock fall 10% or more in a single day or it could drift even lower over the course of several months. The ETF holder’s downside is limited in that company-specific event because that particular stock is but one in a portfolio of 20, 30, 40 or whatever number is being held by the particular ETF.
For example, if shares of Fortinet (FTNT) fall 10% in one day, the most that one stock could impact the HACK ETF is 0.5% because FTNT shares account for just 4.88% of HACK’s holdings. If FTNT shares popped 20% on some company-specific news, it would equate to a 0.9% upward move in HACK shares before taking into account what happened with the other holdings that day.
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A word of caution with these up-and-coming thematic ETFs -- be sure to check the holdings relative to the stated strategy in a bid to ensure proper diversification, as there may not be enough. For example, the U.S. Global Jets ETF (JETS) invests solely in airline operators, such as Southwest Airlines (LUV), United Continental (UAL) and JetBlue (JBLU). But the Robo-Stox Global Robotics and Automation (ROBO) is a more diversified investment that aims to profit from the adoption of robotics and automation as industries look to improve productivity and keep a lid on or cut costs. It features more of a range of holdings that include Deere & Co. (DE), an agricultural and construction equipment company, Lincoln Electric Holdings (LECO), which sells welding, cutting and brazing products in the United States and internationally, as well as others that are on the periphery of a thematic shift. Our rule of thumb is: if you need to overly rationalize what a company does to make it fit a thematic perspective, odds are it shouldn’t be a part of it.
The bottom line is, if you lack the time to roll up your sleeves and dig into specific stocks, ETFs, which trade like stocks but limit risk through diversification, are a viable alternative. As with many things in life, there are trade-offs. With ETFs, you trade that diversification, more often than not, for limited upside. As you sift among the growing list of ETFs, be sure to check for ample trading volume. Be on the lookout for ETFs that are heavily weighted on a few stocks (this limits their diversification) and make sure the holdings reflect the stated investment strategy.
If you want to use a balanced approach of mixing individual stocks with some ETFs, that’s a reasonable strategy. Just be sure your risk profile and your stomach can tolerate the potential downside, as well as the upside, to be had from the more individual stocks you have.
In case you missed it, I encourage you to read my e-letter column from last week, which wrapped up our list of 10 questions to answer before you buy any stock. I also invite you to comment in the space provided below my Eagle Daily Investor commentary.
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