ETFs vs. shares: A guide to similarities and differences

While exchange traded funds (ETFs) and individual shares have plenty of common characteristics, there are important differences between the two investment vehicles.

Learning more about how ETFs and shares compare can help you tailor your portfolio to your investment goals.

What is an ETF unit?

An exchange traded fund (ETF) acts like a basket of individual securities that can be bought and sold in a single trade on a stock exchange. The individual securities within an ETF can be shares, bonds, currencies, commodities, or other investments.

When you buy a unit of an ETF, you become a small part-owner of the underlying pool of investments, much like you do when applying for units in a traditional managed fund. The net asset value (NAV) price of an ETF represents the per-unit value of the fund’s assets less any liabilities.

ETFs have grown exponentially since 1993 when State Street Investment Management launched the first US-listed ETF. Today, investors across the world can choose from thousands of ETFs to meet their individual portfolio needs, from gaining broad market exposure and generating income to accessing difficult-to-reach markets.

What is a share?

A share is a security that gives the holder part ownership of the specific issuing company. Publicly traded shares trade on exchanges like the Australian Securities Exchange (ASX).

ETF vs. shares: similarities

Transparency

The holdings of most ETFs are fully transparent and available daily. This means investors know what they are exposed to at any moment, allowing them to make informed investment decisions. Similarly, when investors hold individual shares, they know what they own.

Broad range of investment options

Both ETFs and shares can be used to gain exposure to a variety of market segments, covering different geographic locations, market capitalisations, styles, sectors, and industries.

Transaction fee or commission

Because ETFs and individual shares are bought and sold on an exchange, they are both generally subject to a brokerage fee. Note that some online brokers offer commission-free trading of some shares and ETFs.

Pricing and trading

Investors can buy and sell ETF units and individual shares on an exchange continuously throughout the trading day. This allows investors to make timely investment decisions and quickly execute in the face of shifting market conditions.

Exchange trading also means the trading prices of both ETFs and shares represent the current market price. With an ETF, the unit price may be slightly more or less than the net asset value (NAV) price.

Exchange trading also means investors can employ a wide range of trading techniques — from buying on margin to placing limit orders.

Dividends

Many companies periodically pay out a portion of their profits to shareholders in the form of dividends. Similarly, ETFs may receive income from the investments they hold, which are in turn distributed to investors who own units of the ETF. Depending on the ETF, this might include dividends from companies, interest coupon payments from fixed income investments, distributions from other trusts like property trusts and so on.

ETFs vs. shares: Differences

Diversification

Passive, or index, ETFs generally track a benchmark index. They provide access to many companies or investments in one trade, whereas individual shares provide exposure to a single company. As such, ETFs remove single-stock risk, or the risk inherent in being exposed to just one company.

Index funds that are diversified across many securities have a lower risk of poor performance arising from just a single company.

Research and management

ETFs are professionally managed funds backed by a team of experts working to meet the goals outlined in the fund’s product disclosure statement. Fund managers are tasked with buying and selling individual holdings in return for a fee.

Expense ratio

ETFs have an expense ratio, which includes management fees and the fund’s total annual operating expenses.

Capital gains distributions

Turnover in an ETF’s holdings — due, for example, to changes in an ETF’s underlying index — often requires the sale of securities. This may in turn trigger the realisation of capital gains. In this scenario, any realised gains (net of any losses) are usually passed on to ETF unit holders. To ensure tax efficiency, where possible ETF managers attempt to limit distributions of realised gains to unitholders. ETFs’ tax-efficient redemption processes aim to “stream” realised gains to brokers and market makers rather than regular unitholders.

Are ETFs or shares right for you?

When choosing whether to add individual shares or ETFs to a portfolio, it’s important to consider your risk tolerance and overall investment objectives. In many instances, ETFs provide a solid foundation for a diversified investing strategy, offering an easy way to gain exposure to a breadth of asset classes, sectors, and regions.

For their part, individual shares allow investors to express views on individual companies, but lack of diversification and may increase overall portfolio risk. Ultimately, the optimal portfolio may contain a blend of shares, ETFs, and other investment products.