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Should an investor buy shares in an ETF or buy the individual stocks that make up the ETF? As we will see, it depends in part on how big the investments are, and how long one wants to hold them.

An Example:

Assumptions:

  • The ETF comprises 25 stocks, and its yearly management fees are 1%.
  • The shares comprising the ETF would cost an average of $100/share.
  • Brokerage fees are $5/trade.
  • Changes in share prices or dividends were not included.

By buying the individual stocks we can create our own "ETP", or exchange traded portfolio. Of course, it's not a true ETF, for many reasons, including the fact that we might be the only one owing it, and the fact that we will have to deal with each stock individually.

Case #1. We buy either $2,500 of shares in the ETF, or alternatively we buy shares of each of the 25 same stocks for $2,500. We hold either investment for one year and then sell them.

Brokers fees (buying and selling)Management feesTotal fees
ETF$10.00$25.00$35.00
ETP (25 stocks)$250.00-$250.00

Case #2. Same as #1, but we buy and hold the ETF shares or the shares in the 25 companies for 5 years and then sell them.

Brokers feesManagement feesTotal fees
ETF$10.00$125.00$135.00
ETP (25 stocks)$250.00-$250.00

Case #3. Same, but we buy and hold for 10 years.

Brokers feesManagement feesTotal fees
ETF$10.00$250.00$260.00
ETP (25 stocks)$250.00-$250.00

It was finally advantageous to make our own "ETP" from the same 25 stocks as the ETF, but only if we bought and held them for 10 years.

Now, let's see what happens when we start to run with the big dogs. We buy $25,000 worth of ETF shares or 10 shares of each of the 25 stocks (again assuming an average price of $100/share).

Case #1. We buy the $25,000 of shares in the ETF or ten shares of each of the 25 stocks for $25,000, hold them for one year and sell them.

Brokers feesManagement feesTotal fees
ETF$10.00$250.00$260.00
ETP$250.00-$250.00

After only one year, it was cheaper to make our own ETP when we invested $25,000, rather than buy $25,000 of an ETF. This explains, at least partially, why big investors seem to buy individual stocks rather than ETFs.

Let's try a real life example, using an ETF, in this case, the Vanguard Information Technology (NYSEARCA:VGT) ETF. (information from Yahoo! Finance, May 6, 2012).

VGT. Share price as of May 4, 2012, 70.57

Top 10 Holdings (57.29% of Total Assets)

CompanySymbol% Assets
Apple Inc.AAPL14.50
International Business MachinesIBM8.48
Microsoft CorporationMSFT7.56
Google Inc.GOOG6.34
Intel CorporationINTC4.92
Oracle CorporationORCL4.01
Cisco Systems, Inc.CSCO3.84
QUALCOMM IncorporatedQCOM3.54
Hewlett-Packard Company CommonHPQ2.06
Visa Inc.V2.04

If we were to buy approximately $25,000 of VGT or approximately $25,000 of just the top ten holdings, and sell those investments after 2 years, then:

Brokers fees (assuming non-Vanguard account holder) at $5/tradeManagement fees - Annual Expense Ratio (.19)Total fees
ETF--VGT$10.00$95.00$105.00
ETP 149.08 shares (14.91 shares of each of the 10 companies) Prices as of May 4, 2012, rounded.$100.00-$100.00
AAPL565
IBM205
MSFT31
GOOG597
INTC28
ORCL28
CSCO19
QCOM62
HPQ24
V118
Total of 10 share prices:1677

Our ETP, comprising approximately $25,000 of the top ten holding of VGT, would match the VGT costs at approximately 2 years.

Note that changes in broker's fees or management fees (for example, the low fees of an index ETF) might affect the point at which making your own ETP becomes less costly than buying shares in an ETF. Also, if an ETF owns stock in hundreds of companies, such as an ETF covering the S&P 500, then trying to buy and sell shares that match the ETF would result in very large brokers' fees.

Conclusion. Buying the individual stocks that make up an ETF results in lower costs when: a) the holding period is long enough, and/or b) the purchase is large enough. So large investors, and "buy and hold" investors, might prefer to buy individual stocks rather than ETFs. On the other hand, those who turn over stock often or who are small investors might prefer ETFs rather than buying and selling the stock that make up the ETF. You might want to look up the stocks in an ETF and the yearly fees, determine how long you want to hold this investment, determine the round trip broker's fees, and then calculate which form of investment has lower costs.

Of course, there many other factors that would affect a decision to buy (or sell) the ETF or the individual stocks that make up the ETF, including the following:

  • Simplicity. Dealing with 25 stocks (or more) takes more work than dealing with one ETF. Calculating the return on your investment would also be more difficult with individual stocks.
  • Liquidity The ETF might be more liquid than the individual stocks, or at least some of them.
  • Flexibility. With individual stocks one can vary the relative percentages of companies included, leave some companies off the list, or add some new ones. One could also sell the individual stocks at different times from each other, or sell them over a long period of time.
  • Tax Consequences. It's possible that dealing with individual stocks could result in different tax consequences than buying and selling shares of the ETF.
  • Power. Some ETFs include investments that ordinary investors could not otherwise easily invest in, such as financial derivatives, futures contracts, stock on foreign stock exchanges, large bonds, etc.

In the future, we may design some sample ETPs together. (By the way, do you prefer the term ETP or PET (Portfolio Exchange Trades)? Thank you. Bill.)

Disclaimer. This article is provided for information and educational purposes only. There is no suggestion, advice or recommendation that you take or refrain from any action, or that you buy, sell, hold, short or borrow any security, or group of securities. No particular investment or group of investments is either recommended, or discouraged. Any given strategy might or might not work at any moment in time. Investing is extremely risky, and markets can move in any direction at any time. For these and other reasons, investors, even the most experienced, can suffer heavy losses at any time. Consult a professional advisor and/or do your own research. I believe that most investors do not beat the market, but I also believe that learning as much as possible about the investments that you make and about your own emotional make-up may improve your performance.

Source: ETFs Vs. Stocks--Should You Start Your Own ETP?

Additional disclosure: I own various Vanguard ETF shares. I have held shares in VGT in the past and may own them in the future.