In the first of our 4-part series exploring different types of ETFs, we looked at how bond ETFs might fit into your portfolio. Later this year, we’ll dive into international stock and bond ETFs, as well as ESG (environmental, social, governance) ETFs.
Today, let’s focus on stock ETFs.
What is a stock ETF?
A stock ETF typically comes prepackaged with hundreds or thousands of individual stocks, providing instant diversification. If 1 stock price falls, the others are there to help pick up the slack, helping reduce your risk of losing money. On the other hand, when you own 1 or a few stocks directly, if a specific stock price falls, your account balance takes a bigger hit.
Most ETFs are index funds. They don’t invest directly in an index—like the S&P 500—because the index is only a representation of a certain market segment.
With so many stocks in a single ETF, who’s overseeing them? That’s where a professional fund manager comes in—investing directly in the stocks the index tracks (or a representative sample). It looks a little like this:
Sometimes an index changes the stocks it tracks or the weighting of each stock. When that happens, the manager is responsible for mirroring those changes to make sure the ETF’s returns don’t stray from its index.
Different types of stock ETFs
A single, all-inclusive stock ETF offers the most efficient way to invest in nearly every aspect of the U.S. and international stock markets. If you’re looking for a more focused investment, you might consider ETFs that concentrate on specific characteristics, such as:
Market capitalization. This refers to the size of a company as measured by the total value of its stock shares. Companies are then categorized based on their capitalization. “Large-cap” companies tend to be more stable than “small-cap” companies, but smaller companies may have more growth potential.
Style. Growth stocks represent expanding companies that reinvest the money they make into their businesses, which ideally results in an increasing stock price. (Examples: Amazon, Apple, Netflix.) Value stocks represent established companies whose price may be undervalued by the market. (Examples: AT&T, Verizon, Coca-Cola.) When you see stock ETFs identified as “blend,” they’re investing in a mix of growth and value stocks.
Geography. Some stock ETFs invest in companies based on their location—U.S. only, non-U.S. only, or a combination. Others focus on companies from developing or emerging markets or from particular countries or regions. The narrower the focus, the greater the potential risk. But that narrow focus also gives you the opportunity to precisely control what’s in your portfolio.
Sector. Sector ETFs focus on one industry, such as energy, technology, or health care—and with that concentration comes potentially more risk.
Stock ETFs vs. individual stocks
Benefits of ETFs over individual stocks
As mentioned earlier, perhaps the greatest difference is the instant diversification an ETF provides. They’re also more convenient for you to own because the fund manager oversees the stocks in the ETF, so you don’t have to research every stock yourself.
They cost less too. When you buy or sell 1 ETF, you pay 1 commission no matter how many stocks are in the ETF. But if you buy or sell stocks individually, you pay a commission every time you buy or sell shares.
As an added bonus, every Vanguard ETF® is available commission-free through a Vanguard Brokerage Account. (Commission-free trading of Vanguard ETFs® applies to trades placed both online and by phone. Learn more about other conditions & costs that may apply.)
Benefits of individual stocks over ETFs
Individual stocks have a slight advantage over ETFs when it comes to capital gains. No matter which you own, when you sell shares for more than you paid, you may have to pay taxes on the capital gains. But it ends there for individual stocks.
With a stock ETF, the manager could be buying or selling individual stocks within the ETF and experiencing gains. At the end of the year, if gains exceed losses, law requires those gains to be paid out to ETF shareholders, and those gains could be taxable—even if you didn’t sell any of your shares. It’s rare, but it happens.
The good news is that 86% of all Vanguard ETFs haven’t had a taxable capital gains distribution in the past 5 years.* And you can ignore all of this if you hold ETFs in a traditional, Roth, or SEP-IRA because their earnings grow tax-deferred.
What about dividends?
There’s not much difference between individual stocks and stock ETFs. While individual stocks may send you dividends directly, stock ETFs gather all the dividends from their underlying stocks, divide them proportionally among all of its investors, and distribute them all at once—usually quarterly.
You can then decide whether you want to accept your dividends as income or reinvest them back into the ETF.
Vanguard ETFs vs. Vanguard index mutual funds
Vanguard ETFs and Vanguard index mutual funds share many of the same characteristics—when you’re comparing similar funds. For example, the performance, risk, and tax efficiency of Vanguard S&P 500 ETF (VOO) and Vanguard 500 Index Fund Admiral™ Shares (VFIAX) are exactly the same because they’re simply different share classes of the same portfolio.
Their trading costs are the same at Vanguard too—that is, zero. There’s no commission to buy or sell any Vanguard ETF in a Vanguard account. Similarly, there are no transaction fees** for any Vanguard mutual funds.
Benefits of ETFs over mutual funds
You can buy any Vanguard ETF for the price of 1 share (as low as $50). Meanwhile, the minimum investment for most Vanguard mutual funds is $3,000. ETFs’ lower minimums could be ideal for newer investors looking for a lower threshold or for experienced investors who want to get into specific areas of the market with less money.
ETFs and mutual funds are also priced differently. Mutual funds have 1 price—the net asset value (NAV). It’s only calculated once a day, after the markets close. Regardless of what time you place your trade, you and everyone else who places a trade on the same day receives the same price, whether you’re buying or selling shares.
ETFs have NAVs too, but they also have market prices (among other prices) that change throughout the day in real time. That means the price you pay or receive can change based on exactly when you place your order, and you’ll know that price when buying or selling shares.
Benefits of mutual funds over ETFs
Vanguard mutual funds let you set up automatic investments, exchanges, and withdrawals. And if you’re 70½ and need to take required minimum distributions (RMDs) from your IRA, you can take them directly from a mutual fund. You don’t have those options with ETFs.
Although ETFs have been around for more than 25 years, misconceptions still abound, such as:
- ETFs are for market-timers. Definitely not! ETFs can be a valuable part of just about any investment portfolio. Buy-and-hold investors shouldn’t feel pressured to change their behavior just because they choose to invest in ETFs.
- ETFs require you to find your own buyer. Another myth. All ETFs can be bought and sold through a Vanguard Brokerage Account, just like individual stocks.
Could stock ETFs be right for you?
Before you make any decisions, consider your asset allocation—how you divide your money among stocks, bonds, and cash. That will drive your returns more than any specific investment selection.
Beyond that, stock ETFs are well-suited for almost any investor, including buy-and-hold investors saving for a long-term goal, such as retirement. In fact, if you have a long time horizon, you may want to hold a higher percentage of stock ETFs in your portfolio to give you the best opportunity for growth. And even retirees may want to use a small percentage of stock ETFs in their portfolios to help offset inflation.
Which Vanguard stock mutual funds have corresponding ETFs?
The following tables match Vanguard stock ETFs to their Vanguard index mutual fund counterparts.
For the most all-inclusive, broadly diversified global stock investment
For global diversification split between U.S. and international exposure
For U.S stock ETFs:
For international stock ETFs
*Source: Morningstar, Inc., as of December 31, 2018.
**Very few Vanguard funds charge fees when you buy and sell shares. The fees are designed to help those funds cover higher transaction costs and protect long-term investors by discouraging short-term, speculative trading. Fees vary from 0.25% to 1.00% of the amount of the transaction.