Stocks vs. ETF’s: which are better?

When we try and decide if we should buy a sector ETF vs. a good stock, we want to examine the variability of stocks within that sector. Some stocks within a sector might massively outperform their peers. Others might underperform the group. This is called dispersion of returns within a sector. Sectors with stocks that don’t vary too much from the mean (average return) do not offer stock pickers an advantage. The performance of all companies in these sectors tends to be similar. A great example of this type of sector is the Canadian banks. Beyond a couple of outliers or regional plays like Laurentian Bank (LB-T) and Canadian Western Bank (CWB-T), the Canadian banks tend to move together – largely led by the big six. That’s because there really isn’t a lot of room for the banks to offer unique or entrepreneurial advantages over each other. Same thing with utilities on both sides of the border. They are highly regulated, have fixed assets and product lines, and can’t offer much in the way of growth or entrepreneurial advantages over their competitors. Since the dispersion of returns amongst utilities and banks tends to be narrow, picking a stock from each sector doesn’t offer meaningfully higher returns for the added risk.

Contrast the Canadian banking sector and utilities sector to the technology sector. Here, we have some pretty big dispersion of returns. Take a look at the two search engine giants Google (GOOGL) and Yahoo (YHOO). Google, which we at ValueTrend own, is up about 50% since the end of 2014, while Yahoo is down about 20% in the same period!

Investment strategy: individual stocks in the technology sector are better than a sector ETF due to greater dispersion of returnsInvestment strategy: individual stocks in the technology sector are better than a sector ETF due to greater dispersion of returns

 

The same observation applies to the retail sector. The behemoth of low price merchandise, Walmart (WMT-US) is down almost 20% since the end of 2014. Meanwhile, discount merchandise and wholesale club Costco (COST-US) is up about 20% over the same period. We hold a position in Costco.

Investment strategy: ETFs in the retail sector are better in general than individual stocks due to less dispersion of returns

Investment strategy: ETFs in the retail sector are better in general than individual stocks due to less dispersion of returns

 

Stock-picking offers an advantage over ETFs when there is a wide dispersion of returns from the mean – as is the case in the retail and technology sectors. You have an advantage by using a rigorous analysis process to separate the stock with the best potential from the stocks with the worst potential in those sectors. I am a fan of utilizing both ETF’s and individual stocks in an investor’s portfolio. The managed platforms that we run at ValueTrend are currently allocated to hold about 20% ETF’s, and 80% individual stocks. While we do attempt to achieve market out-performance through individual stock analysis, sometimes we choose to take a position in low-variance sectors to exploit the trend of the index without the added individual security risk.  Like most things in life, there is a time and place for everything.

4 Comments

  • Very well written. A future followup would be active ETFs vs passive ETFs. Do the higher MERs of the active ETFs add much value? I suspect the numbers will show either go with a stock-picker like yourself and use passive ETFs. Active ETFs probably just fall in the middle. The number would be interesting.

    p.s. You just might be able to score a few new clients who are disappointed with those active ETFs.

    Reply
    • Thanks Robert
      The thing about active ETF’s is that they are like mutual funds. Most are not worthy of their MER, but some are quite worthy of paying up –for example, my pal Brooke Thackray advises for the Horizons Seasonal ETF-HAC on the TSX-and its delivered exactly what the promise is year after year–steady, solid returns. True–His ETF has high fees after you take the performance bonus into account, but the returns are net the fees–so the HAC ETF is very well worth those fees. We own the fund in our small accounts for clients (TFSA’s etc). However, there are some poor performing active ETF’s– too many to count. Seeing as I gave kudos to a Horizons ETF, I’ll pick on another Horizons fund to beat up–their Auspice Managed Futures ETF is run inefficiently and in my humble opinion not worth the fees. I owned it for a while, and learned the hard way that their way of going long and short is not efficient –So–same distributor (Horizons), two actively managed funds, but two different managers–One worth his salt, the other…questionable – at least in that particular fund they run for horizons. Thus–you have to take them on a case by case basis.

      Reply

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