When Do Single Stocks Trump ETFs?

The benefits of ETF (exchange-traded fund) investing are well substantiated and generally well understood: The average investor benefits tremendously from low fees, diversification, and convenience. However, it’s also valuable to know the benefits of single-stock investing, and the relative advantages of owning a share of stock directly versus owning a basket of stocks through a pooled vehicle. In this article, you’ll gain an understanding of why, under the right circumstances, it may be beneficial to own single stocks.

1. More control over tax triggers

By owning stocks directly, you will be exposed to the complete performance of a particular company. For each stock you own, you’ll have gains or losses.

In the case of significant stock price gains over time, you will be left with sizable long-term capital gains, which are taxable when you sell if you invest in a regular taxable brokerage account. If you decide to own single stocks, you can engage in a practice called “tax loss harvesting,” or using capital losses from losing stock positions to offset gains from winning ones. By reducing capital gains through loss harvesting, you’ll have the opportunity to lower your tax bill.

This strategy is muted with ETFs (unless you own multiple funds) and tends to be utilized more frequently when an investor holds many individual stocks. With ETFs and mutual funds, you don’t have any control over trades the portfolio manager makes, and you also don’t have control over fund redemptions by other investors. Actions taken on the behalf of others can impact you — albeit in a minor way — which can make owning single stocks marginally more attractive from a tax control standpoint.

2. You’re the portfolio manager

If you want to construct a customized portfolio with your best ideas, buying stocks directly is your best choice. With ultimate control over dividend yield, tax efficiency, and sector focus, you have the ability to choose your own adventure. For instance, say you want to create a high-yield dividend stock portfolio to create a new passive income stream, and you’re willing to spend the time to find the best 15-25 dividend stocks for the next 10 years. Single-stock ownership will make sense for you. This can be accomplished by buying companies that have the characteristics for which you’ve screened at no cost other than the time spent researching.

ETFs will answer the call for basic investing at nearly zero cost if you’re simply trying to invest in broad market indexes, but won’t offer you the opportunity to manage the finer details of your portfolio. Being the portfolio manager isn’t attractive to everyone, but if it is for you, you’ll likely want to incorporate single stocks into the mix.

Image source: Getty Images.

3. It can be cheaper — sometimes

Let’s imagine you’re interested in a particular investment theme for the next decade and beyond — space exploration, for example. Rather than buying an entire thematic ETF like the Procure Space ETF (NASDAQ: UFO), which will expose you to many failing companies and will also require you to pay a significant expense ratio of nearly 100 basis points, you could choose to buy the top two to three stocks in the ETF to act as a proxy for the fund. You’ll avoid the expense ratio and gain exposure to a few companies that are leading the space — Maxar Technologies (NYSE: MAXR), Virgin Galactic Holdings (NYSE: SPCE), and Dish Network (NASDAQ: DISH) would be the relevant stocks in this example.

Broad-market index mutual funds and ETFs are a minimalist’s dream: Once they’re bought in your portfolio, no further action is required other than the occasional rebalance or withdrawal. Index investing speaks to a specific type of investor — one that is likely to be less engaged with the day-to-day movement of the market (of course, not a bad thing) and perhaps less interested in determining which stocks will outperform relative to their current valuation. This is a great way to invest, but some investors enjoy stock analysis and can be very successful in creating their own portfolios. If you’re looking to recreate a plain vanilla index mutual fund, it’s likely not worth the cost savings to have to purchase 500 stocks and constantly monitor them.

Not for everyone, but it can work

Buying single stocks does offer benefits in the way of increased control, better tax management, and the ability to fine-tune your portfolio. If you have a specific objective that calls for a greater portfolio management commitment, owning single stocks will be a suitable method of investment. Moreover, if you are concerned about taxes, owning single stocks will allow a greater opportunity to manage your annual tax liability. However, for the lay investor, a portfolio of simply constructed index mutual funds or ETFs with low expense ratios will more than suffice.

10 stocks we like better than Maxar Technologies Ltd.

When investing geniuses David and Tom Gardner have a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

David and Tom just revealed what they believe are the ten best stocks for investors to buy right now… and Maxar Technologies Ltd. wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

See the 10 stocks

*Stock Advisor returns as of August 1, 2020

Sam Swenson, CFA, CPA has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Virgin Galactic Holdings Inc. The Motley Fool recommends MAXAR TECHNOLOGIES LTD. The Motley Fool has a disclosure policy.