We hear about the advantages of ETFs all the time. They provide diversification in a single trade, low costs and tax efficiency. And investors clearly agree with these benefits as money keeps flowing into ETFs. I don’t have a problem with ETFs. I have them in my portfolio and I keep investing more money in them. But I’m going to play devil’s advocate and highlight some clear advantages of owning individual shares.

Are shares a better way of achieving your goals?

We all have different goals but we can start with one of the most common ones – getting the highest return possible. I have some concerns with this goal as I think it encourages poor investor behaviour and performance chasing. But there is no denying that this is the overarching motivation for many investors.

If you find the right shares to buy you can do significantly better than an ETF. You don’t even need to fill your portfolio with high performing shares. You only need to find a couple winners.

As an example, we can consider an investor in Australian shares with 20 holdings in a portfolio with an equal allocation of 5%. This hypothetical investor owned 19 shares that didn’t appreciate at all over the past five years. The 20th share was Pro Medicus. Over the past 5 years that portfolio would have slightly outpaced the ASX 200 from a price return perspective at 22.82% vs 22.61% for the index. That is just from picking one winner – albeit a share with one of the highest returns in Australia.

This illustrates that when picking individual shares it isn’t about getting all of your picks right or even most of your picks rights. It is about finding a few long-term winners that significantly outperform. This is easy in theory. In practice it is very hard to do. It is hard to find those shares and it is hard to hold onto them through the inevitable ups and down.

To demonstrate the difficulty of finding the right shares we can look at the ASX 200 over the past year. In the past year the ASX 200 has returned 12.42%. Of the 200 shares in the index 94 have a return higher than 12.42%. 44 shares have a positive return but lower than the index. 62 have a negative return.

Returns over the past year have been strong and markets and the economy are in decent shape. Yet 31% of the shares in the index have a negative return. And this is only a one-year period. It gets harder over the long-term and the herd of outperforming shares thins.
There is research that demonstrates this and further shows how difficult it is to find winners.

A professor at Arizona State named Hendrik Bessembinder looked at every share in the US since 1926. 86 shares have accounted for half the total return of the stock market. All of the wealth was created by the thousand top performing shares. 96 percent of shares in the US earned a return that matched a one-month treasury bill.

Every investor is free to draw their own conclusion from this data. To me it seems obvious that the secret to getting the highest performance is to buy individual shares. But to do this an investor needs to find those 10-baggers that Peter Lynch talks about in One Up on Wall Street. This isn’t impossible. But it is hard and if you take this route you should have a strategy to build a portfolio that can outperform. If you can’t at least articulate your competitive advantage over other investors it might be better to stick with ETFs.

What about other goals?

I think a much stronger case can be made for holding individual shares if your goal isn’t simply to outperform the market. I am an income investor and I think there is a compelling argument that individual shares fit this strategy better than ETFs.

Holding individual shares means that I can let my income compound through rising dividends and the power of dividend reinvestment. The combination of these factors can create a powerful income compounding machine.

You just can’t do this with most income ETFs. The approach that most income ETFs take involves constantly adjusting their portfolios. This may be through a forward-looking dividend screen or a backward looking dividend screen. The former is preferable but either way as prices move yields are impacted. This changes the companies in the ETF. And while the current yield is generally high for these ETFs it breaks the cycle of compounding.

As an income investor what matters most is the yield at cost. What I care about as an income investor is not the current yield of my portfolio but how much income I am earning per dollar that I’ve invested historically.

Over the long-term the best way to grow income is to find shares with decent yields and dividend growth. Dividend ETFs don’t generally do this. They are always searching for the highest yields using a variety of screens. When a share has a lower yield it is replaced with a higher yielding share. This keeps the yield high but generally there is no growth unless the yield of the highest yielding shares increases over time. This would only really happen in a falling market.

Below is an example using two popular dividend ETFs in Australia.

ETF income

The lack of growth in the total distributions is evident from the chart. The distributions have fluctuated but are at similar levels to a decadee ago. Depending on your goals and the role a dividend ETF plays in your portfolio this may be acceptable. It may not. It is important to understand anything you buy and how that investment may or may not contribute to your goals. I try and balance high current yields and dividend growth in my portfolio. I have an allocation to dividend ETFs to support high current yields. I wouldn’t consider most dividend ETFs to support income growth.

ETF fees

ETFs are mostly low cost. That is a good thing. But remember that investing in individual shares is free. There are transaction costs associated with both and those transaction costs may be higher with individual shares given that fewer ETFs are needed for a diversified portfolio. However, if you are a long-term investor there are no fees once you’ve purchased a share.

In the following chart I’ve looked at a $100,000 portfolio that is held for 30 years at a 7% return per year. I’ve picked three popular ETFs at different fee levels. Vanguard Australian Shares VAS is cheap at just 0.07%. Vanguard Diversified High Growth VDHG is a multi-asset ETF with a fee of 0.27%. And the thematic ETF Global X Battery Tech & Lithium ACDC has a high fee of 0.69%.

Impact of fees

As you can see the impact of fees over the long-term are significant. The impact of even a low fee matters because it compounds – or more accurately, it reduces the compounding of your portfolio. An investor in the Vanguard Australian Shares ETF ends up paying $14,799 in fees with 2% less money at the end of the 30 years. At the other extreme an investor in ACDC pays a shocking $134,286 in fees and has nearly 18% less money. Fees have a large impact on the outcome you achieve. 

Distributed capital gains

There is no way to avoid paying taxes. But there is an advantage to choosing when you pay taxes. You can wait to sell until you’ve established an account-based pension in your super during retirement and there are no taxes. You can wait to sell in a year when your income levels are lower and you pay a lower marginal tax rate. You can offset taxes by selling winners and losers in your portfolio during the same financial year. You can also carry forward losses. The point is that you have control over when capital gains and losses are generated with individual shares.

For both ETFs and individual shares any dividend income will be taxed. However, the distribution from an ETF is not all dividend income. Capital gains are distributed as well if an appreciated share is sold within the ETF. That means you can pay capital gains taxes even if you don’t sell the ETF.

For an ETF like VAS which tracks a market capitalisation weighted index this isn’t much of a problem. There will be small changes as the ASX 300 composition changes as one share replaces another but these are small parts of the portfolio.

Gor an ETF that is actively managed or tracks an index that is frequently reconstituted and / or rebalanced this may be a bigger problem. I am going to use Vanguard Australian Shares High Yield ETF VHY as an example. This is an ETF that I happen to own so I thought it would be a good example. VHY has the potential for high-turnover. The index the ETF tracks ranks shares based on the forecast dividend yield from the ASX 200. The top ranked shares that meet that and other criteria are included in the ETF.  

Every six months the shares in the ASX 200 are re-ranked. And since forward yield is a function of price and future dividend estimates the shares with the highest forecast yields can change significantly. If the rankings change shares are sold and replaced with new purchases. If the shares removed from the ETF were sold at a higher price than they were purcahsed a capital gain is generated and distributed to holders of the ETF.

The last four quarterly distributions for VHY totalled $4.24. By going through the Fund Payment Notice on Vanguard’s website I found the amount of those distributions that were made up of capital gains. It is $1.04 or close to 25%.

Taxes are an unavoidable part of investing. In the case of an ETF that is likely to continue to generate capital gains an investor needs to weigh what is being accomplished by turning over the portfolio against the costs of paying additional taxes.

The role that VHY plays in my portfolio is to generate high levels of current income to balance out the lower yields from the dividend growth shares I purchase. I’m comfortable that VHY uses forward dividend estimates as a basis to avoid dividend traps. And I accept that this will result in turnover and capital gains. Make sure you are considering the same trade-offs with ETFs held in your portfolio.   

Final thoughts

Investors don’t need to choose between individual shares and ETFs. This gives us the ability to find the right types of investments or the right mix to suit our personal circumstances and goals. Investments are simply a means to an end. They are a tool we use to accomplish our goals and investors should consider which tool is right for the job.

I will finish this article as I started it by declaring that I don’t have anything against ETFs and I use them in my own portfolio. But I do worry that some investors have lost the perspective that an ETF is simply a wrapper around the actual investments that are being purchased and sold – the underlying shares and bonds held in the ETF. And it is an imperfect wrapper. There are fees involved and there are tax consequences. And the much-heralded liquidity of ETFs means that most investors trade them far too often.

Morningstar’s annual Mind the Gap study shows that most investors underperform their investments by up to 1.7% a year. A study conducted by UTS explored whether individual investors benefit from the use of ETFs. The study found that portfolio performance when investors used ETFs was lower than when they didn’t.

It wasn’t a small loss. The study found that ETF portfolios underperformed non-ETF portfolios by 2.3% a year. The loss is the result of buying ETFs at the wrong time rather than choosing the wrong ETFs. A critical finding in the study was that ETF portfolios did actually outperform if the investor bought the investment and held it for the long-term. 

I have two primary goals for my portfolio. In my non-retirement accounts I am trying to generate income that I can spend prior to retirement. I’ve chosen mostly individual shares as I believe they are better vehicle to build a growing stream of income. My goal for my retirement savings is to support future withdrawals supported by assets sales and income. I have a much higher allocation to passive ETFs in those accounts because I’m happy to get the market returns. In both cases I’m simply trying to find the best tool for the job.

There seems little doubt that ETFs will continue to grow at the expense of managed funds and holding individual shares. Just make sure that you are using them correctly in your portfolio. And make sure that most of your focus is not on the investments in your portfolio but how you are investing. Your own behaviour will be the biggest driver of the outcome you achieve - no matter what you hold in your portfolio.   

I would love to hear your thoughts on the advantages and disadvantages of ETFs. Email me at mark.lamonica1@morningstar.com  

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