Which is better – owning individual securities or mutual funds/exchange traded funds (ETFs)? The question isn’t easy to answer because a lot depends on what you want to accomplish. Cost is one factor to consider. Owning individual securities typically involves a transaction cost to purchase. Once you own the security, there is usually no additional expense to hold it. Mutual funds typically have ongoing expenses. In most cases those annual expenses can be kept to a minimum by using passively managed funds and generally even lower with ETFs.
Another important factor related to cost is tax efficiency. One advantage of investing in individual securities is the control you have over paying taxes. You don’t have to pay tax on your gains as long as you don’t sell the security. Taxes are due when you sell which is entirely your decision to make. This is not the case with mutual funds and ETFs. You will have to pay tax on gains if you sell your fund shares, but you can also end up paying taxes on capital gains even if you don’t sell. When the mutual fund sells some of its holdings internally, it’s required by law to pass on those gains as distributions to its shareholders. You should be particularly mindful when investing in funds when the stock market has risen over a period of time because many equity funds may have considerable unrealized capital gains.
Convenience and diversification are important advantages of owning mutual funds and ETFs. Some investors don’t have the time or interest in following individual securities. Researching individual securities and staying current on issues affecting those securities is very time consuming. Investing in a mutual fund or an ETF generally takes less research and monitoring.
Finally, there is no reason an investor needs to choose one or the other. You can use both when building an investment strategy. Individual securities could be held in taxable accounts and mutual funds in tax deferred accounts for tax efficiency. Mutual funds and/or ETFs could be used for the riskier parts of the markets like small companies or emerging markets while individual securities are used for established companies to reduce risk. It’s important to understand the advantages and disadvantages to each approach to determine the best way to proceed.