What is a stock?

In simple terms, a stock or share is a unit of ownership in a company or financial asset. Buying a share/stock makes you a shareholder and entitles you to an equal claim on the company’s profits, as well as losses. Any declared profits are distributed equally amongst shareholders in the form of dividends. Most companies issue their shares as ‘common stock’.

What is an Exchange Traded Fund?

An ETF is a collective investment vehicle similar to a traditional ‘mutual’ fund. By buying a share of an ETF, your money is pooled with others’ and used to invest in a portfolio of shares, commodities or bonds.

Exchange Traded Funds are marketable securities that track a certain index (e.g. the FTSE 100) and as their name suggests, are traded on major stock exchanges, just like shares.

Both stocks/shares and ETFs are bought via a stockbroker, are held in exactly the same way, and their prices can fluctuate during the day.

An ETF can be considered to be a basket that can contain all kinds of investment, including stocks, commodities and bonds and allows you to invest in a variety of companies.

Trading Stocks vs ETFs

• If the company grows and becomes more valuable, your share will be worth more.
• If available, dividends (a share of the profits) offer an almost guaranteed partial return on your investment each year. What’s more, many dividend-paying companies increase their pay-outs each year.
• Common shareholders have some control over the business as they have voting rights and are allowed to attend shareholder meetings.

Benefits

• While you can invest very little, your money will buy you a small piece of a well-diversified portfolio of investments (which could include hundreds of companies).
• As costs are shared between all investors, ETFs can be a cost-effective way to invest.
• As most ETFs are index tracking funds, they have lower charges than other funds – and can even be cheaper than index trackers.
• Unlike shares, stamp duty is not payable on overseas domiciled ETFs that trade in London.
• You can trade ETFs very quickly.
• Choosing the right ETF can give you exposure to foreign indexes/boom sectors.

Risks

• Buying shares in a single company can be extremely risky – if the company gets into difficulties you risk losing your money.
• Stamp duty or tax is payable on most UK share purchases.

Benefits vs Risks of ETFs

While ETFs sound very similar to index tracking funds – both are low cost methods that allow investors to track an index with similar levels of risk and return attributes – there is an important difference.

While index tracker funds trade and are valued only at the end of the day when the markets close, ETFs can trade in real-time, just like stocks and shares. This means they can be traded again and again during trading hours. While this flexibility may be appealing, be warned, the charges can quickly obliterate any profit made.

Two types of ETF

Physical ETFs are the traditional ETF; they actually buy and hold the underlying assets and securities according to their weighting in the index they are tracking (such as the FTSE) to mirror the returns of the underlying index.

In contrast, the ominously named synthetic ETF willtrack the index without actually buying the underlying assets. They are often based around a legal contract between, for example, an ETF provider and a counterparty, such as an investment bank, to deliver the chosen index return. Not only are they difficult for investors to understand, but they introduce extra counterparty risk (should the bank, for example, become insolvent).

• Costs can soon mount up if you trade ETFs constantly.

• Exit fees can eat into your profits.

Synthetic ETFs, with their limited transparency and higher risks, have attracted the attention of regulators around the world and while they can be found in Europe and Asia (where they are differentiated by an ‘X’ at the start of their names), they are far less common in the USA.

What makes ETFs different to Index Trackers?

You may have read that ETFs offer a tax benefit for the investor in the way in which they are managed. Sadly, this is only true for those in the USA – in the UK there is no real tax advantage, although ETF gains within the tax efficient wrappers of an ISA or SIPP are generally tax-free and don’t incur stamp duty upon purchase.

In addition, before investing it is worth checking that the ETF you are interested in has been given ‘reporting’ or ‘distributing’ status, to ensure gains are only subject to Capital Gains Tax (CGT), and not the more expensive Income Tax rates.

Physical vs Synthetic ETFs

With stocks/shares you will typically pay stamp duty when you buy them. You will pay income tax on your dividends and CGT when you come to sell them. Stocks/shares held within an ISA will avoid the income tax on dividends and CGT on the profits.

Stocks vs ETFs?

Of course, both come with their own degrees of risk and require a significant level of research before committing our money. But with returns that can far outweigh those earned in savings accounts, investing may well be worth that time and trouble.