It’s been a couple of years since I have been building my stock portfolio, I discovered ETFs a couple of months ago. While I find the concept interesting, I really wanted to make up my mind and understand what are the Pros & Cons of ETFs and why one should invest in ETFs over Stocks.
My aim in life is to be able to live on passive income. So my strategy is rather to buy, hold and cash in dividends. I particularly like high yield dividend stocks with stable performance such as pipelines stocks or Real Estate Investment trusts because of their predictable income.
However, I came to the conclusion that it’s an utopia to think that I will be able to keep those stocks forever. Almost every company ends up disappearing.
Most of the salt mining companies disappeared when people started to use canned food & refrigerators for preserving food.
Retail real-estate stocks seem to have a hard time adapting to e-commerce.
DVD rental companies close one after the other when Netflix started to be on each smart TV or computer.
The list is endless. It’s called innovation, it’s a really great mechanism but it makes the idea of buying a stock and holding it forever almost impossible. Every company ends up dying ultimately (except a few isolated cases – some banks from the 15th century are still in operations).
The good news is that ETFs now exists. They replicate automatically existing indexes. If you want to learn what is an ETF, there is a pretty good video from Investopedia.
In this article, I would like to cover the Pros & Cons of ETFs and why one should invest in ETFs over Stocks.
👍 – Diversification
As a rule of thumb, the more stock you hold, the more diversification there is in your portfolio. Most of the ETFs are measuring indexes made up of 30 or more stocks – The MSCI World Index even consists of approx 1600 companies!
ETFs also allow you to bet on the economy of a country (Dax index for German companies) or on an industry such as healthcare companies for example. The beauty of it is that you do not have to try to do any stock-picking any longer because the optimization of the index mentioned below does it for you.
👍 – Automatic optimization
What I like the most with ETFs is the automatic optimization. Let’s imagine you hold some shares of an ETF replicating the Dow Jones Industrial Average, which is an index measuring the performance of the 30 largest industrial stocks in the US. If the market capitalization of one of the index constituents decreases too much, then the stock will be ejected from the index and replaced by a stock having a higher market capitalization.
For example, in July 2018, General Electric Company was dropped from the average and replaced automatically by Walgreens Boots Alliance, Inc. The same thing happened in March 2015 when AT&T was dropped from the average and replaced by Apple Inc.
To me, passive optimization is the most important aspect that makes me invest in ETFs. Thanks to it, I do not have the burden of knowing “when to sell”. Which fits very well my “possessive personality”.
👍 – ETFs investing neutralizes the Fear of Missing Out
It happens all the time no? You read something exciting about a specific stock; “Hydrogen is the future”, “Space cargo will save mankind”, “Stock X is very cheap now”, “Amazon is doing so great”, “Russia is starting to pick up again”. Immediately you feel like buying the stock or at least researching more. And then you are gone for days of analysis of that specific stock. Or even worse, you might just end up buying the stock without any proper analysis. Does this sound familiar? Well, it’s normal because it’s psychologically very hard to just imagine missing out on a good trend.
This is also why I love ETFs. Especially ETFs such as MSCI World or MSCI Emerging markets. The reason is that those ETFs are made out of more than thousands of different stocks. Hence, there is a very high chance that the stock you just read about is already in one of the ETF you own. At least for me, it calms my need to own that stock because I already own it.
For example, I was reading a lot about Tesla (How original right?) and then I realized that I already owned it via the MSCI World Index. So I moved on with my life. If you are interested in a specific stock and want to see in which Index the stock is present, you can have a look at the following ETFs exposure lookup.
👍 – Lower volatility
At the time of the redaction of this article, the world is facing a rough health crisis. People are forced to stay home, malls are closed, airplanes are grounded, etc… Every financial crisis is not hitting all the industries or geographies in the same way. For example, during the Coronavirus crisis, the oil & travel industry has been hit much harder than the health or e-commerce industry for example. It’s almost impossible to guess which industry is going to be hit next.
Having a broad ETF in the portfolio will generally offer less volatility against a financial crisis. However, the opposite is true, ETFs will in general also offer lower gains than isolated stocks during a bull market. It all depends on your risk profile.
👍 – No upfront dividend tax (In Germany)
I am based in Germany, so I can only talk about holding ETFs in Germany. When dividends of a stock are credited to my account, there is immediately an upfront tax payment on the dividend itself. It can vary from 0% to 30% depending on the country where the stock is and the broker you use.
For example :
If you hold Total SA via De Giro being in Germany, you will face a 30% upfront dividend tax
If you hold Vereit Inc via De Giro being in Germany, you will face a 15% upfront dividend tax
If you hold Royal Bank of Canada via Interactive Broker being based in Germany, you will face a 15% upfront dividend tax.
The beauty of ETFs is that you won’t pay any “upfront” dividend tax, you will only pay the tax on capital gain when you will do your tax declaration, which can be up to 24 months after you got paid the dividend. So this creates a significant liquidity advantage.
NB: Please note that I am neither an expert tax advisor nor lawyer, nothing in the above is guaranteed to be correct. I base the content above on my personal experience and own research. If any doubt, do your own research and consult your tax advisor or lawyer before taking any decision.
👍 – ETFs passive investing is time-saving
Here a list of things you will not have to do any longer if you decide to follow a “buy and hold” ETF strategy:
Check multiple time daily the price of a stock you bought
Watch for earning calls and shareholder meeting summaries
Track the performance of the competition to see if the stock you bought is still the market leader
Anticipate trends and adjust your portfolio accordingly
Follow the news about a stock you bought
Follow the news about the industry of your stock
Worry about a financial scandal in one of the stock you hold (E.g. Steinhoff International)
Worry about the stock cutting its dividend
Think about when is the best time to sell the stock
I tried to estimate how much I was investing in picking stock before I moved to ETF long term investing. I came to the conclusion that ETF investing saved me approximately 6-7 hours per week.
👎 – ETFs tendentially focus and “feed” large caps
Most of the indexes that ETFs replicate work in the following way:
Follow an ETF logic. E.g. :
a physical area (Europe / Germany / Latam)
an industry (Healthcare / Travel)
a characteristic (High dividend yield / Deep Value)
Take the (#) companies top-down from the highest market capitalization to the lowest.
In other words, first comes the “logic” of the ETF then “top-down” from the highest to lowest capitalization company. As a result, big companies are also going to be over represented in a lot of various ETFs because of their size.
Allianz, for example, will be present in the following ETFs – see screenshots below :
This is also the reason why when a stock makes it to the “next level index”, we tend to see an increase in price because the stock is immediately / automatically bought because it just entered the index – example of Walgreen Boots Alliance. The opposite is true when a stock is dropped by an index, its stock price tends to decrease even quicker.
👎 – Complications if an ETF is closing or the ETF emitter is going bankrupt
Let’s imagine one of the ETF you invested some money in is not able to attract enough interest from other investors. As an ETF loses assets, the fund will lose investors, increasing the cost of operating per investor. Here is what happens if an ETF closes:
Investors are notified 3-4 weeks that the ETF will be closed. In the meantime, the ETF still operates as usual.
Investors can then:
Wait for the ETFs to be closed, then get a payment covering the value of the underlying assets
Sell immediately. When doing so, the price of the ETF closing will not decrease because remember, the ETF replicates an index. But no one will be willing to buy the ETF from you at the “index” price. This is called: Bid/ask spread.
For example, if ETF emitter Shield Inc. is offering an ETF replicating the S&P 500, if Shield Inc announces the closing of their S&P 500 ETF, this will have no impact on the S&P 500 itself.
The closing of an ETF is not dramatic per se. But it’s still annoying if a) you did not want to sell the asset and b) because this could mess up your tax estimations.
👎 – ETFs have are not for free
The ETF emitter is providing a service. To be more precise, the ETF emitter needs, among others, to create a financial product that is available to buy via a broker, that automatically buys and sells stocks to always match the weighting of the index it is replicating, manage dividends payments etc… All of this needs resources to be executed profitable for the emitter – ETF emitters are not a charity. For this reason, ETFs providers charge you a yearly fee. You won’t see it billed from your account, it will be automatically taken from the position itself.
This is the reason why when you compare the DAX with a DAX replicating ETF such as the iShares Core DAX, you will see that the spread between both lines increases with time. This is how you pay the bill.
Additionally, the easier the index is to replicate, the lower will be the yearly fee. If the replicated index is complicated or based on stocks that are in exotic countries, then the fee will be higher.
For example from the same provider (Blackrock) on the MSCI World (Easy to replicate) applies a fee or Total Expense Ratio (TER) of 0.2% of the position value. From the same provider (still Blackrock) but this time on the MSCI Emerging Market, the TER is 0.68%. Why? Because it’s simply more expensive/complicated to buy stocks from China / Malaysia / Indonesia / Bolivia than buying stocks from the USA, Canada, UK or Germany available in almost every broker already.
Please note that on average, ETFs are still much cheaper (TER between 0.2 and 0.8%) than actively managed investment funds (TER between 2.5 to 5%). Also, actively managed funds often charge entry fees while a lot of ETFs are entirely free to buy. Here, for example, the free ETF list of Degiro.
In this article, we discussed the Pros and Cons of investing in ETFs. Are ETFs the best way to invest? It depends on your investor profile. However, the less time you have to allocate to your investment strategy, the more ETFs are made for you.
ETFs tendentially focus and “feed” large caps
Complicated liquidation process
ETFs investing neutralizes the Fear of Missing Out
ETFs are not for free
No upfront dividend tax (In Germany)
ETFs passive investing is time-saving
My ETF strategy
I personally try to reach >50% of my portfolio in an ETF. Because I want to generate passive income, I generally focus on dividend-paying ETFs. I also want to protect myself from the risk of closing the ETF mentioned above, so I try to buy the same indexes from different emitters. For example, the All-World Indexes from HSBC, Vanguard, and Ishares.
NB: Please note that I am neither an expert tax advisor, nor a lawyer, nor a financial advisor. Nothing in the above is guaranteed to be correct. I base the content above on my personal experience and own research. If any doubt, do your own research and consult your tax advisor or lawyer before taking any decision.