Four Reasons We Like to Own Individual Stocks vs ETFs and Mutual Funds

Stocks vs ETFs and Mutual Funds

Narwhal’s focus on an individual stock selection strategy is unique compared to many peers in the industry. This strategy is more time consuming and nuanced than an ETF or mutual fund strategy, but Narwhal sees the value of this approach as more than worth the effort. When comparing the strategy of individual stock selection to an ETFs and mutual fund strategy, there are the four main drivers that lead us to favor individual stocks for our client's portfolios.

1. Stocks vs ETFs and Mutual Funds: Understand what you are invested in.

As irrational as we as consumers can be sometimes, it is rare that we throw significant sums of money at things without having some level of conviction as to why we are doing it. This same thought process should hold true in investing, and is one of the biggest reasons why we prefer buying individual stocks over ETFs and mutual funds. Within a typical individual stock portfolio, we hold anywhere from 40-50 different companies. Each one of those companies has been researched thoroughly and discussed at length by the members of our investment committee. Quite literally, there is a 20-30 page internally generated research paper on each stock we hold in a portfolio. Now consider an ETF, which is typically made up of hundreds of different companies. An investor that buys shares of a fund is instantly a holder of all of the underlying companies that exist within that fund. This is a very convenient way to invest, but there is no practical way to have a legitimate understand of each of the underlying companies in a fund. More likely than not, if I were to scroll through the list of companies in the S&P 500, there would be a number of companies that I have never heard of. Investing in these companies blindly through an S&P 500 ETF (like IVV, which is a common ETF) without any understanding of a large number of the underlying companies creates unnecessary risk for the investor. This risk could be avoided by owning a portfolio of individual companies that the investor has a deep understand of and a high level of conviction in. A natural response might be to think that the diversification benefits of owning a fund (because they are comprised of so many companies) outweigh the uncertainty of investing in companies blindly, but research shows that more companies doesn’t necessarily equal a more diversified portfolio. If you want to read more on that topic, check out an older blog titled: “Risk and Diversification: Comparing Fund and Individual Security Investment Strategies”.

2. Stocks vs ETFs and Mutual Funds: Consider the cost of investing.

Every fund held by an investor carries additional costs, most commonly in the form of a fee called an expense ratio. The expense ratio is what the fund management company charges all investors for the ability to invest in their fund. Depending on the fund, the expense ratio can range from insignificant to exorbitantly expensive, and more often than not, investors aren’t aware that these fees exist. The lack of clarity surrounding expense ratios often leads to a much higher cost of investing than investors realize, especially in instances when investors are paying a financial advisor who uses a fund strategy. Clients are quoted a management fee from the advisor but are rarely told that the funds within the accounts are also drawing fees. So, what could look like a typical 1% fee to invest with an advisor may actually be costing the client much more, depending on the funds being held.

The cost associated with holding ETFs and mutual funds is one reasons why we choose to avoid those investment options. While there are quality funds that are well structured with relatively low expense ratios, many are expensive. The use of an individual stock selection strategy can reduce the cost burden felt by investors. If you want to know the expense ratio associated with a fund you hold, Morningstar.com is a great resource to find that information.

3. Stocks vs ETFs and Mutual Funds: Tax management.

The flexibility to manage around taxes within a portfolio is a huge value add for clients and one that can only be carried out effectively in a portfolio made up of individual stocks. I dove into this topic in more detail in a previous blog post titled “Funds vs. Individual Securities: Part One - Tax Efficiency”, so if you want more detail on the topic, feel free to read through that post. At a high level, owning individual stocks creates flexibility within investment accounts in two main ways. The first is important when a client wants to pull money from their account. In a scenario where an investor owns one fund that is up, say, 20% for the year, the client will be faced with a 20% gain when they sell any portion of those assets in order to take out the cash. There is no way to work around the taxes on the 20% gain no matter the amount of money they take out. In a scenario where an investor owns a portfolio of individual stocks that is also up 20% for the year, it is likely that out of the 40-50 stocks within the portfolio, there are some winners, some stocks that are flat, and some losers. This allows the investor to selectively sell certain positions that may have a loss or a small gain and raise the cash in ways that can often allow the investor to access money from an account in a completely tax neutral way.

The second tax advantage to holding individual stocks instead of funds is the day to day tax management opportunity that it provides. To give a quick example, there are times when we research a stock and excitedly buy a position because of our optimism about the future performance of the company. Sometimes that works out and the position performs well from the beginning, but there are instances when we were a little early to buy in and the performance may trend down initially. In instances like that, when your inclination may be to hold the stock, feeling confident that the price will move back up in time, it may actually be to your advantage to sell the stock, realize the loss on the position, and buy back in 30 days later (the required wait time to rebuy a stock you’ve sold). This allows you to gain the tax advantage of realizing a loss that can help reduce your tax burden, while quickly jumping back into the stock as to not miss out on the investment opportunity.

In both the above examples, the underlying companies in a fund are moving up and down just like they would in an individual stock portfolio. However, in a fund you are handcuffed and can’t leverage the tax benefits by being selective in the companies that you sell. That can only effectively be done in a portfolio of individual companies.

4. Stocks vs ETFs and Mutual Funds: The chance to outperform.

The last reason that we prefer the active management of individual stocks vs ETFs (more specifically index funds) is that this strategy creates the chance to outperform the market. We say chance because beating the market is a difficult task and far from a sure thing, but what is a sure thing is that any chance to outperform the market is eliminated if you hold only index funds. This is because index funds are designed to track the performance of the market, and by very definition cannot beat the market. An individual stock strategy creates that chance for outperformance. A greater level of detail is provided on this topic in a past post titled “Funds vs Individual Securities: Part 3 – Performance” which highlights the facts that, while we don’t claim that we are right and anyone who thinks otherwise is wrong, we are highly convicted in our strategy and will continue to chase that outperformance.

Conclusion

All told, we believe strongly in the value that we provide for our clients through the use of an individual stock strategy. Each of the above points offer a good reason to consider utilizing a similar strategy, but when these points are considered in conjunction, (and executed effectively) it can provide meaningful value for the investor. If you have any questions or follow-up comments regarding the topic of individual stock management, please feel free to reach out.