ETFs vs Individual Stocks

The UK investment landscape is changing quickly, with about 19 million investors now representing 36% of the adult population. Since 2022, we've seen an influx of 3.5 million new investors, marking a 21% increase. This rise in interest has led to a significant growth in Exchange-Traded Funds (ETFs), which have seen ownership rise by 57% during this time. The London Stock Exchange currently lists over 2,350 ETF products, together valued at £1 trillion in assets. Among younger investors aged 18-34, ETF ownership in Europe has jumped by 19%, fueled by the convenience of digital platforms, with 80% of this group investing in ETFs online.

Today, we will explore the high-level differences between ETFs and individual stocks. We will weigh the pros and cons of each investment type and consider current market data along with practical implications for you as you build and maintain your portfolio.

Key Differences Between ETFs and Individual Stocks

Instant Diversification vs. Individual Stock Picking

An ETF can be thought of as a 'basket of stocks' - rather than buying one stock in an industry, buying an ETF means buying a bundle of shares. For example, a FTSE 250 ETF means you buy one 'share' but that share is underpinned by the FTSE 250 index. This means that the standout advantage of an ETF is its ability to offer instant diversification across hundreds of companies without needing to buy each stock separately. If one stock within the ETF performs poorly, its impact on your overall investment is cushioned.

Investing in individual stocks can require considerable market research and insight, but the reward is a higher potential upside. At the same time, this can be riskier - while picking the right stocks can yield notable returns, it comes with a risk of loss. Notably, studies reveal that only 20% of stocks survive and outperform over 20 years, highlighting the difficulty of consistently making successful stock picks and underscoring the active nature of individual stock picking.

Legal & General Cyber Security ETF Fact Sheet: This ETF would allow me to gain exposure to major players in the cyber security sector, without taking on the risk of only one of them.

Cost Considerations

ETFs generally feature lower annual fees, often under 0.1%. This cost efficiency is particularly attractive to long-term investors focused on maximizing their returns. In contrast, trading individual stocks can incur higher transaction fees. This is only made notably bad if you are frequently buying and selling, and incentivises stock owners to buy and hold for the long run.

Tax implications also play a role in investment costs. Both ETFs and individual stocks in the UK can enjoy the same treatment within Individual Savings Accounts (ISAs), allowing for £20,000 to be invested per year that is tax-free on capital gains and dividends. However, outside ISAs, ETFs often prove more tax-efficient due to their lower turnover rates, leading to fewer taxable events.

Understanding UK Tax Implications

Getting a grasp on tax implications is a key factor in managing your investment portfolio. ISAs provide tax benefits for both ETFs and individual stocks, letting you grow your investments without incurring capital gains or dividend taxes.

For those investing outside ISAs, the current capital gains tax (CGT) allowance is £3,000. Basic rate taxpayers face an 18% tax on gains, while higher rate taxpayers face 24%. Dividends are also taxed, with a £500 allowance for basic rate taxpayers taxed at 8.75% and higher-rate taxpayers at 33.75%. Given these factors, ETFs may be more appealing for investors wanting to minimize tax impacts.

Practical Considerations for Investors

Time Commitment and Investment Knowledge

For busy investors seeking broad market exposure with less management, ETFs can be a smart choice. They require minimal time commitment compared to the ongoing research necessary for picking stocks. This can make ETFs suitable for those who may not have the ability or desire for in-depth analysis. On the flip side, individual stock picking can be more attractive to investors who are more familiar with market trends and willing to devote time to research. The idea is that those investors are rewarded for the additional time and risk.

Assessing Risk Tolerance and Investment Goals

When choosing between ETFs and individual stocks, it’s important to evaluate your risk tolerance and investment goals. ETFs can offer a more stable investment experience, making them suitable for conservative investors. Individual stocks, however, can provide greater upside potential for those willing to accept the associated risks.

At the same time, it is important to consider where these may sit in your portfolio. If you are looking for strong dividends or you are considering holdings with historic returns, then a UK equity ETF may not be ideal. Many ETFs don't pay dividends even if the underlying assets do, and UK indices also don't often see much in the way of strong returns. For example, in the past five years, a FTSE 100 ETF would have returned only just under 50%; an S&P 500 ETF would have returned just under 90%. At the same time, many FTSE 100 companies, which you have heard of and hold the 'Blue Chips' seal of approval status, outperformed both of these indices significantly. For example, in the same period:

• Rolls Royce Holdings returned 1,118%

• Next Plc returned 97%

• Airtel Africa returned 246%

• Aviva returned 126%

• Intercontinental Hotels Group returned 114%

• Shell PLC returned 127%

• Coca-Cola Europacific Partners returned 97%

Yes, you can get exposure to the fizzy drink giant Coca Cola via the London Stock Exchange. It even outperformed its 'full fat' American listing over the last five years.

Of course, past performance is by no means an indicator of future returns. Nevertheless, the point is that these returns all took place during a period when the index did not outperform. Given it's a relatively small index, some could find that the research needed to stock pick with confidence is indeed possible. With various strategies, they can also mitigate some of the risk when investing in individual stocks.

Making Your Choice

Both ETFs and individual stocks offer unique benefits and drawbacks, serving different types of investors. In the right context, ETFs deliver instant diversification, lower costs, and tax efficiency, making them an excellent option for busy investors or those wishing for broad market exposure. Individual stocks require more time and effort but can yield higher returns for those who are up for the challenge.

The good thing is, you don't need to choose just one. A common strategy is the core-satellite approach, where 70-80% of a portfolio is allocated to ETFs for stability and diversification, while individual stocks comprise the remaining portion to target higher returns.

Ultimately, the decision between ETFs and individual stocks should align with your investment experience, time, risk tolerance, and overall financial goals. Both paths can lead to success based on your specific objectives and investment timelines. As the UK investment scene continues to grow, understanding these choices will empower you to make informed decisions that support your financial aspirations.