Understanding ETFs

The investment industry is no stranger to fads. In the 1970’s it was the so-called Nifty Fifty. In the 1980’s it was junk bonds. In the 1990’s it was dot-coms, and in the 2000’s it was the big commodity boom. Most recently, the industry has been busy promoting a new type of investment known as an exchange-traded fund, or ETF. In fact, fund companies have introduced more than six hundred of these new funds over the past five years. [1]

There are now ETFs that allow you to invest in every corner of virtually every market, from the U.S. to Chile to China. You can choose to bet on a single industry, a single country or an entire region, if you want. ETFs also let investors bet on unconventional assets such as oil and gas or gold and silver. Should you have a negative view of a particular market, there are ETFs that will allow you to “go short” – that is, to bet on a price decline – or to amplify your bet with borrowed money. There are even ETFs that promise to replicate complicated hedge fund-like strategies.

Against this backdrop, with so much industry attention focused on ETFs, it is worth examining their merits relative to individual stocks to see whether they might be appropriate for your portfolio. To this end, we can compare them across four dimensions: simplicity, balance, taxes and control.

Simplicity: The original promise of ETFs was simplicity; they allowed an investor to create a diversified portfolio with just a single purchase. While it is certainly true that it is easy to purchase any one ETF, the proliferation of ETFs has, ironically, contributed to an increase in complexity for investors. Together with traditional mutual funds, there are now more than 7,000 funds available to investors in the United States. Indeed, the ETF market has become so crowded that there are now more funds than there are stocks listed on U.S. exchanges. [2] As a result, today the task of choosing a portfolio of ETFs can require as much work as choosing a portfolio of individual stocks.

Balance: Research has shown that individual investors are prone to making a set of common, and costly, mistakes when they buy individual stocks. They overpay for “hot” stocks, they trade too much and they fail to diversify sufficiently. [3] ETFs, on the other hand, aggregate a large number of stocks into a single investment, and because of this, they may make it easier to avoid these kinds of mistakes. Unfortunately, ETF portfolios are not perfect either. When a stock’s price is going up, for example, most ETFs will buy more of that stock – exactly the opposite of what you might want to do. [4] For these reasons, you will always want to understand exactly what you own, whether you choose to invest in funds or in individual stocks.

Tax considerations: ETFs are often perceived as being tax-efficient investments. However, investors should be careful not to generalize. An ETF is only tax-efficient if it is explicitly managed with that goal in mind. There is, however, nothing inherently tax efficient about an ETF. In fact, individual stocks can provide you with certain tax advantages that ETFs cannot. That is because, when you own individual stocks, each holding has its own tax status in terms of gains or losses. This gives you tremendous flexibility to manage your taxes when you make sales. Suppose, for example, that you need to pay a tuition bill. If you sell a stock at a profit, you’ll be on the hook for the associated taxes. If, on the other hand, you sell a little bit less of that first stock and also sell some shares of another stock that is down, you can lessen the overall tax impact of your sales. In contrast, ETFs don’t allow you to disaggregate their holdings to control taxes in that way.

Individual securities can also offer tax advantages if you have charitable intent. Instead of donating shares of an ETF, which again just represents the aggregated value of all of its holdings, it is more advantageous to donate individual shares of stock. That is because you can select the holdings that have the largest gains, allowing you to sidestep the largest potential tax bills. From the charity’s perspective, this doesn’t make a difference because they are exempt from taxes anyway. Following the 2015 increase in capital gains taxes and the new healthcare-related investment tax, this has become an even more valuable benefit.

Control: When you own individual stocks, you have complete control over what you own. When you own an ETF, on the other hand, it’s a package deal, for better or for worse; you own shares in everything that the ETF owns. What this means is that you may become an unwitting shareholder in a company that you would not otherwise want to own. A fund tracking the S&P 500 Index, for example, will own shares in all of the big tobacco manufacturers along with other companies that might not necessarily align with your values. Similarly, international funds may be invested across the world – in China, in Russia and in other countries whose values you may not share.


In the final analysis, it is important to recognize that every investment strategy has its own unique set of potential benefits and drawbacks. There is no one “perfect” strategy. As a result, what is most important is to stay focused on your goals and to employ the strategy – or combination of strategies – that best fits those goals.


[1] 2015 Investment Company Fact Book, Investment Company Institute, http://www.icifactbook.org/fb_ch3.html#assets, Retrieved January 31, 2016.

[2] As of May 3, 2016, The Center for Research in Security Price’s U.S. Total Market Index included 3,664 stocks.

[3] Barber, Brad M. and Terrance Odean, “The Behavior of Individual Investors,” September 2011. http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1872211 (Retrieved December 1, 2015).

[4] ETF.com Screener & Database, www.etf.com/etfanalytics/etf-finder, Retrieved August 17, 2016.