There are many ways to invest in any individual asset category. They all have different expenses, returns, complexities, risks, and tax consequences. In the stock asset category, investing in individual company stocks, chosen by you and your financial advisor, is uncommon due to complexity, increased risk, and time required. Most advisors recommend investing in a more diversified group of stocks through funds (Mutual fund or Exchange Traded Fund) or separately managed accounts (SMA).
Choosing individual companies to invest in is very difficult, time consuming and likely to perform worse than investing in all companies that make up the stock market. If your stock asset category is composed of less than 10-15 stocks you will have increased risk/reward than the overall stock market. If decreasing risk/volatility and chance of loss is important than you must have more than 30 individual stocks in your portfolio. Decreasing risk through diversification also reduces return and makes it more difficult to outperform the overall market.
There are 2 ways to invest in the overall stock market. Active stock selection and index investing. There are thousands of stock indexes that have different risks and returns. Some of the common indexes include the Dow Jones Industrial Average (DJIA) Index tracking 30 US companies, the S&P 500 index tracking the 500 largest US companies, the Russell 1000 index tracking the largest 1000 US companies, and the Wilshire 5000 index covering all publicly traded companies based in the US.
There are 2 ways to invest in an index, through a mutual fund or an exchange traded fund (ETF). A separately managed account (SMA) invests in a diversified basket of stocks that hopes to replicate or beat the index return. Index mutual funds and index ETF have nearly identical performance but differ in tax efficiency and trading process. ETFs due to their structure have no internal trading capital gains while similarly invested mutual funds may have taxable annual capital gain distributions. Also, ETFs trade like stocks which allows for intraday trading while mutual funds are all bought/sold at the end of the day pricing. Generally, ETFs are preferred over mutual funds for index investing due to these 2 differences.
Index investing expense ratios (internal fees) are generally very low for stock indexes. For example. the ETF ticker SPY, which invests in the S&P 500 index has an expense ratio of 0.09% and has returned an average annual return of 12.30% after expenses over the last 10 years. The ETF ticker VTI invests in the total US stock market and has an expense ratio of 0.02% and has returned 11.77% after expenses annually over the past 10 years. The ETF ticker DIA invests in 30 US companies, has an expense ratio of 0.16% and has returned 10.94% after expenses annually over the past 10 years.
It is difficult to compare SMAs and index ETFs. SMAs are typically more expensive than index ETFs, so the big question is; are there any SMA managers that are able to beat the index ETF after expenses over a 10 year period. The vast majority of actively managed mutual funds are unable to beat the index managed mutual funds, after expenses, over a 10 year period. Unfortunately, there is less data on SMA performance.
If you find an SMA manager that is able to beat the S&P 500 index over 10 years after expenses, please let me know.
