Single Stocks & ETFs Do Mix

September 10, 2021

While investors often turn to ETFs to gain broad, diversified exposure to an array of asset classes, that doesn’t mean stocks can’t have a place in your portfolio, too.

There are many similarities between ETFs and stocks. Both trade on an exchange, usually with a high level of liquidity. Both can be used to invest in a specific industry. Both might pay dividends.

But there are also additional considerations that should be made when considering a stock in addition to a diversified ETF portfolio. Whether it is a short-term, tactical idea or a longer-term, buy-and-hold type of position, here are some factors to keep in mind when figuring out how to construct a portfolio that holds both ETFs and stocks.

Concentration At Macro Level

When buying and allocating to a single stock within our portfolio, it can be easy for us to think about our position size to that stock as our exposure to that company.

However, many ETFs—including core holdings that are likely to be found in your portfolio—can have large allocations to some holdings. The sensitivity of your portfolio to movements in a stock might be higher than you think, if you’re not considering your portfolio as a whole.

Take the SPDR S&P 500 ETF Trust (SPY). Over a quarter of the S&P 500 is found in the top 10 names within the portfolio, predominantly concentrated in mega-cap tech names such as Apple or Microsoft.

 

Pop-up Image

Chart courtesy of FactSet

(For a larger view, click on the image above)

 

Supplementing your large cap exposure with some of these stocks would have been a benefit for your portfolio over the last several years.

 

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

 

Chart courtesy of StockCharts.com

 

The top two names, Apple and Microsoft, have outperformed SPY over the trailing three years. The tech names are up over 184% in the past three years, while the broad ETF has returned 65%.

In periods of outperformance, supplementing your SPY holding with a position in one of these names would be additive to portfolio returns. The share price increase was reflected within not only the return of the stocks, but SPY’s returns as well.

However, the reverse is also true. Consider an investor who holds 50% of her portfolio in SPY, has another 10% of hers portfolio in Amazon and the remaining 40% in a bond ETF.

Since Amazon is 3.9% of SPY, considering these holdings in aggregate means the portfolio has about 12% in Amazon—20% more than the stock position size of 10%.

 

Chart courtesy of StockCharts.com

 

In years like this one when Amazon is underperforming SPY, you would have been better off forgoing Amazon’s stock while holding a 60% position in SPY.

Pros & Cons

One benefit of allocating some of your portfolio to single stocks is the lower cost. As you are managing that portion of the portfolio yourself, there is no expense ratio to pay and most brokerages offer no-commission trading. While core positions such as SPY or the iShares Core U.S. Aggregate Bond ETF (AGG) tend to be low cost, other more niche or thematic ETFs could be considerably more expensive.

For example, an investor might prefer to buy Tesla stock rather than the Simplify Volt RoboCar Disruption and Tech ETF (VCAR), which comes with a 0.95% expense ratio. Tesla makes up 15.5% of the portfolio, which is a play on autonomous driving. And it’s likely that Tesla would reap the benefit from any positive drivers of return in the autonomous driving space.

 

Pop-up Image

Chart courtesy of FactSet

(For a larger view, click on the image above)

 

However, Tesla would also come with more stock-specific risk, even relative to the concentrated VCAR.

 

(Use our stock finder tool to find an ETF’s allocation to a certain stock.)

 

Cost Comes With Benefits

Diversification aside, it’s important to consider whether the expense ratio might be worth paying due to the professional management of the fund. Both passive and active ETFs have benefits that might be worth the cost.

The benefit of passive, rules-based ETFs is that the index construction will rely on a specific methodology to rebalance the fund on a regular basis, with no regard for timing or market outlook.

While the timing may not always be advantageous, it is not clouded by emotion or bias—something that we are all prone to having as individual investors.

When it comes to active ETFs, even portfolio managers are subject to these cognitive biases when it comes to investments. However, investment teams often have multiple analysts with ample data to vet research ideas and offer opinions on whether a holding should be included within a specific portfolio.

The idea is that a team will be able to discuss the pros and cons of a particular investment, diminishing the influence of any one person’s biases.

Case-By-Case Basis

As adding individual stock holdings to your portfolio has its pros and cons, there is no single answer as to whether it is right for your portfolio.

Doing so comes with the potential for increased return if the stock performs well. But it also comes with increased risk and the need for a higher level of vigilance, especially if these are tactical plays. Tread carefully.

Contact Jessica Ferringer at [email protected] or follow her on Twitter

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