Say you've decided that you want to invest in a particular sector. Now you need to decide whether to buy stocks or an exchange-traded fund (ETF). Investors encounter this question every day. Many are under the impression that if you buy an ETF, you are stuck with receiving the average return in the sector. This is not necessarily true, depending on the characteristics of the sector. (See: Building an All-ETF Portfolio.)

Making this choice is no different from any other investment decision. As always, you want to look for ways to reduce your risk. Of course, you want to generate a return that beats the market (creating alpha.) Reducing the volatility of an investment is the general method of mitigating risk. Most rational investors give up some upside potential to prevent a potentially catastrophic loss. An investment that offers diversification across an industry group should reduce the portfolio's volatility. This is one way that diversification through ETFs works in your favor.

Alpha is the ability of an investment to outperform its benchmark. Any time you can fashion a more stable alpha, you will be able to experience a higher return on your investment. There is a general belief that you must own stocks, rather than an ETF, to beat the market. This notion is not always correct. Being in the right sector can lead to achieving alpha, as well. (See: A Deeper Look at Alpha)

When Stock Picking Might Work

Industries or situations where there is a wide dispersion of returns, or instances in which ratios and other forms of fundamental analysis could be used to spot mispricing, offer stock-pickers an opportunity to exceed.

Maybe you have a good insight on how well a company is performing, based on your research and experience. This insight gives you an advantage that you can use to lower your risk and achieve a better return. Good research can create value added investment opportunities, rewarding the stock investor.

The retail industry is one group in which stock picking might offer better opportunities than buying an ETF that covers the sector. Companies in the sector tend to have a wide dispersion of returns based on the particular products they carry, creating an opportunity for the astute stock picker to do well. (See: Analyzing Retail Stocks)

For example, recently you have noticed that your daughter and her friends prefer a particular retailer. Upon further investigation, you find the company has upgraded its stores and hired new product management people. This led to the recent rollout of new products that have caught the eye of your daughter's age group. So far, the market has not noticed. This type of perspective (and your research) might give you an edge in picking the stock over buying a retail ETF.

Company insight through a legal or sociological perspective may provide investment opportunities that are not immediately captured in market prices. When such an environment is determined for a particular sector, where there is much return dispersion, single-stock investments can provide a higher return than a diversified approach.

When an ETF Might Be the Best Choice

Sectors that have a narrow dispersion of returns from the mean do not offer stock pickers an advantage when trying to generate market-beating returns. The performance of all companies in these sectors tends to be similar. For these sectors, the overall performance is fairly similar to the performance of any one stock. The utilities and consumer staples industries fall into this category. In this case, investors need to decide how much of their portfolio to allocate to the sector overall, rather than pick specific stocks. Since the dispersion of returns from utilities and consumer staples tends to be narrow; picking a stock does not offer sufficiently higher return for the risk that is inherent in owning individual securities. Since ETFs pass through the dividends that are paid by the stocks in the sector, investors receive that benefit as well. (See: How to Pick the Best ETF)

Often, the stocks in a particular sector are subject to disperse returns, yet investors are unable to select those securities which are likely to continue outperforming. Therefore, they cannot find a way to lower risk and enhance their potential returns by picking one or more stocks in the sector.

If the drivers of the performance of the company are more difficult to understand, you might consider the ETF. These companies may possess complicated technology or processes that cause them to underperform or do well. Perhaps performance depends on the successful development and sale of a new unproven technology. The dispersion of returns is wide, and the odds of finding a winner can be quite low. The biotechnology industry is a good example, as many of these companies depend on the successful development and sale of a new drug. If the development of the new drug does not meet expectations in the series of trials, or the FDA does not approve the drug application, the company faces a bleak future. On the other hand, if the FDA approves the drug, investors in the company can be highly rewarded.

Certain commodities and specialty technology groups such as semiconductors fit the category where ETFs may be the preferred alternative. For example, if you believe that now is a good time to invest in the mining sector, you may want to gain specific industry exposure. However, you are concerned that some stocks might encounter political problems harming their production. In this case, it is prudent to buy into the sector rather than a specific stock, since it reduces your risk. You can still benefit from growth in the overall sector, especially if it outperforms the overall market.

The Bottom Line

When deciding whether to pick stocks or select an ETF, look at the risk and the potential return that can be achieved. Stock-picking offers an advantage over ETFs when there is a wide dispersion of returns from the mean. And you can gain an advantage using your knowledge of the industry or the stock. (See: 5 ETFs Flaws You Shouldn't Overlook)

ETFs offer advantages over stocks in two situations. First, when the return from stocks in the sector has a narrow dispersion around the mean, an ETF might be the best choice. Second, if you are unable to gain an advantage through knowledge of the company, an ETF is your best choice. 

Whether picking stocks or an ETF, you need to stay up to date on the sector or the stock in order to understand the underlying investment fundamentals. You do not want to see all of your good work go down the drain as time passes.

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