When To Buy A Stock; When To Buy An ETF

September 23, 2014

Having guidelines on when to buy a single security or an ETF can enhance returns.

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today’s article is by Doug Sandler, chief equity officer at Richmond, Va.-based RiverFront Investment Group.

As money managers who are measured by our performance, we’re constantly searching for tools and strategies that could potentially give us an advantage over our benchmarks and our peers. And we believe that exchange-traded funds, if used appropriately, can give us just such an advantage.

At RiverFront, ETFs enable us to not only implement our strategic and tactical asset allocations, they also serve an important purpose in our domestic equity portfolios. We want to share our strategies for answering what we think is one of the toughest questions facing equity investors: “When is it better to buy an ETF over a stock?”

Opportunity For Outperformance

Not every industry offers equal opportunities to outperform. In some industries, as illustrated in Figure 1 below, returns are extremely varied among companies, with many stocks delivering returns well above the industry average and many delivering returns well below. We believe an industry with wide dispersion of returns—dispersion being the location of a set of values relative to a mean or average level—offers the stock picker a field of opportunities from which to add value.

Computer hardware, Internet services, software and retail are just a few examples of industries in which returns have historically been widely dispersed.

Conversely, there are industries in which there is little deviation among company returns. The performance of most of the stocks in these industries largely reflects industry-average returns, with minimal variance between the best performers and worst performers.

In tightly dispersed industries, such as utilities and beverages (see Figure 2), we believe the decision whether to be overweight or underweight the industry is generally more important than the actual stocks that one might select.

Making The Decision

When determining whether to purchase a stock or an ETF, we believe one of an investor’s first questions should be: “Is this an industry that has historically generated a broad dispersion of returns?”

If the answer is no, we believe an investor’s time is better spent applying their stock-picking skills elsewhere, and we would favor the use of ETFs.

Figure 1

Fertile_Field

Industries like media, retail, Internet


 

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