ETFs vs buying individual shares and bonds – what investors need to know

2024 is shaping up to be a record year for exchange traded funds (ETFs).

Net new money invested into ETFs globally is on track to hit a new record high this year, and the total value of ETFs is set to pass $14tn.

But how do ETFs compare to buying individual investments, like shares and bonds?

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. Investments rise and fall in value, so you could get back less than you invest.

What are ETFs?

ETFs hold a basket of underlying investments, with the aim to track a particular index, stock market or commodity.

For example, an ETF might track the FTSE 100 index which represents the largest 100 companies in the UK. ETFs often hold investments like shares and bonds.

ETFs have some very similar characteristics to funds.

For example, their value is based on the performance of the underlying investments and they’re ‘open-ended’, so units can be created and destroyed based on supply and demand.

However, the main difference is that ETFs trade on an exchange, with a live market price. This means that the price of a share of an ETF changes throughout the day. The price of a unit in a fund, however, is set once a day and stays fixed until the next price update the following day.

As ETFs trade like shares, buying and selling will be subject to share dealing charges within your HL account. If investing in funds, you won’t pay any dealing charges.

ETFs vs individual investments – costs

ETFs give you access to a range of shares, bonds or commodities in one single investment. You can usually invest in the individual holdings that make up an index yourself, but there are extra costs involved.

Every time you buy and sell an individual share or bond you will have to pay a dealing charge.

You could also pay other charges like UK stamp duty. This is a government tax that you pay when you buy UK-listed shares.

Whereas if you buy shares in an ETF, you get to invest in lots of investments, but only pay one dealing charge. You also won’t pay stamp duty on ETFs.

An ETF is managed by a team of professional fund managers and their job is to make sure the ETF tracks its chosen index as closely as possible.

They might do this by investing in every holding in the index and in the same proportion. Or they might invest in a sample of holdings that represent the broader index.

An index is rebalanced regularly, usually four times a year. When holdings are added or removed from an index, an ETF will buy and sell the same holdings to match the makeup of the index.

By the time you allow for taxes (capital gains tax and stamp duties for example) and potential dealing costs, it would cost a lot for an individual investor to rebalance their portfolio in line with the index.

It can also take a lot of time. Whereas ETF issuers have the scale and resource to reduce trading costs and all you have to do is buy a single investment.

ETFs aren’t completely free of costs though.

Because of the ongoing management of ETFs, you pay an annual management charge to the ETF issuer. This is reflected in the returns of the ETF, so you don’t have to pay the charge separately.

The ETF issuer covers all the costs involved with running the ETF, plus factors like dealing charges, spreads and withholding taxes. If you bought the underlying investments yourself, you would have to take all these factors into consideration. Some ETFs may also have additional costs not covered under the on-going management charge so you should read the important documents for an ETF before investing.

You don’t pay an annual management charge when investing in individual shares or bonds. Instead, it’s up to you to manage those investments yourself.

Topping up investment portfolios is something else to keep in mind.

By choosing to invest in all of the shares or bonds in an index directly, each time you top up your investments, you’ll have to buy all of the shares and bonds again in proportion to their weight in the index. If you choose to use an ETF instead, then you only have to buy the ETF and the fund managers will do this for you.

ETFs vs individual investments – performance

In reality, it’s not practical for investors to buy every holding in an index and trade every time the index rebalances because of the costs and time involved.

Instead, you might choose to invest in a handful of individual shares or bonds to invest in a particular market. But, by doing that, it’s almost a certainty that the group of shares or bonds you invest in will perform differently to the index as a whole.

It’s also more likely that the specific shares or bonds you buy will have more and bigger ups and downs compared to an ETF.

ETFs tend to be less volatile because they’re likely to be more diversified across lots of different investments.

On any given day, some holdings will fall in value and others will rise. However, holding more investments, which is more likely with an ETF, should hopefully help smooth performance. That means you’ll likely see fewer, and smaller, ups and downs although, of course, there are no guarantees.

Should you invest in ETFs?

If you don’t have the time or expertise to pick individual investments or would prefer an easy low-cost way to invest, you could consider investing in ETFs or adding more to your portfolio.

ETFs offer so much choice – whether you want to track the global stock market or a certain index like the FTSE 100 or S&P 500. And there are ETFs that focus on specific sectors, countries and themes if that’s what you’re looking for.