Once you’ve made up your mind that you want to invest in a specific sector, you need to start thinking of whether to buy individual stocks or an exchange-traded fund (ETF).
Investors who are at this junction usually think that ETFs only give the average of the return of a particular sector. But that isn’t always the case.
This kind of choice is very similar to any other investment decisions. Your goal, of course, is to reduce your risk while also generating profits that outperform the market.
Minimizing the volatility of an investment is usually the way to go. Many investors are also willing to give up some upside potential if that means they could protect their holdings from drastic losses.
And when you invest in an asset that offers quick diversification across an industry group, you also minimize your portfolio’s volatility.
And that is one of the ways exchange-traded funds are working for the investor.
There are industries and situations where there is a wide dispersion of returns. There are also times when ratios and other fundamental analysis metrics could be used to find mispricing. And this is where stock picking strategies could work superbly.
Based on research and experience, you may gain insights into how well a company is performing. And of course, this insight gives you an advantage to lower your risk and achieve a better return.
Good research can bring value-added investment opportunities, giving the investor some profits.
Company insight via a legal or sociological perspective may also provide investment opportunities that are not reflected right away in market prices.
When you see such a condition in a particular sector, individual stock picking strategies can offer better results that a diversified technique.
When is ETF Better?
Sectors with narrow dispersion of returns from the average do not provide stock pickers an edge when they try to achieve returns that beat the market. That’s because the performance of the companies within these sectors are usually the same.
For such sectors, the broader market’s performance is usually similar to the performance of any single stock. Examples of industries that belong to this category are consumer staples and utilities.
For this situation, the investors need to decide how much of their portfolio is to be allocated to the overall sector, instead of picking individual stocks.
Because the dispersion of returns from consumer staples and utilities is usually narrow, individual stock picking does not provide adequately higher return for the risk that is innate in owning individual assets.
Because ETFs pass through dividends that stocks in the sector pay, investors also get that additional benefit.
Oftentimes, the stocks in a specific sector are subject to disperse returns. However, investors cannot select those securities that are probably going to continue outperforming.
As a result, they cannot lower the risk and enhance their potential returns by picking one or more stocks in the sector.
If the drivers behind the company’s performance are complex and too difficult to understand, they investing in ETFs might be a better move.