To begin with, ETFs and stocks are both traded on exchanges that allow public access and usually deal in shares of publicly-traded companies.
Market forces determine the price
A stock reflects a company’s share price according to its recent performance, profitability, growth expectations, and perceived value in the marketplace. It’s the culmination of supply and demand for one unit of equity (stock) in a particular company.
A company has an initial offering when it first becomes available on the open market — this is when you buy your first stock at whatever price it goes out with (its debut).
After that, prices fluctuate as traders buy and sell.
On the other hand, ETFs are priced continuously during market hours based on the net asset value (NAV) of the underlying securities.
The NAV is computed by considering the total market value of all the assets held by the fund minus liabilities. The price of an ETF share is always a fraction of the value of the underlying assets.
The key difference between stocks and ETFs is that stocks represent ownership in a single company, while ETFs provide diversification across several companies.
This diversification comes with two main benefits: reducing risk since you’re not putting all your eggs in one basket. It also allows investors to benefit from exposure to different sectors and industries.
While ETFs track a basket of underlying assets, the stock market represents a single entity: an individual company or corporation.
You can buy and sell stocks in that one company based on its current performance and your expectations for future growth.
But you won’t be owning shares of other companies when you invest in a particular stock.
Additionally, a share price can decline even if the value of the underlying assets held by the ETF increases.
Alternatively, if all the underlying investments decline in value but liabilities do not, the NAV will decline, and ETF shares may trade at a premium to their NAV (called “Creation Units”).
Stock prices may rise or fall due to macroeconomic factors that affect all companies, whereas an ETF’s fee may be more stable since it is tied to multiple stocks.
The SEC describes ETFs as “a type of investment company whose shares represent an interest in a portfolio of securities that track the performance of a particular market index.”
While both ETFs and individual stocks share market risk to some extent, stock prices may rise or fall due to macroeconomic factors that affect all companies.
An ETF’s price is more stable since it is tied to multiple stocks. Additionally, owning shares of an ETF does not require you to keep your money idle as with a money market account; there can be intra-day trading within a brokerage account where you can buy and sell at the desired price any time during market hours.
Since each unit of an ETF represents ownership in one company (its “creation unit”), selling part of your position will also involve selling the underlying securities.
If you own a stock and the company pays dividends, you’ll receive periodic payments from the company based on how many shares you own. However, if the company doesn’t pay a premium or goes bankrupt, you’ll have nothing to show for your investment. On the other hand, ETFs typically payout dividends on a monthly or quarterly basis.
These distributions come from the interest and dividends earned by the underlying securities in the fund’s portfolio. Thus, even if an ETF experiences losses in its underlying security holdings, it may still distribute positive cash flows to its shareholders.
Creation and redemption
Another key difference between stocks and ETFs is the creation and redeeming. When you buy a stock, you become a part-owner of that company. If you want to sell your shares, you need to find a buyer willing to pay the current market price.
On the other hand, ETFs are created when an investor deposits cash into an account at a brokerage firm and requests units of the ETF. The ETF issuer will then buy the underlying securities and create new shares.
These newly created shares will be deposited into the investor’s account.
When investors want to redeem their shares, they can do so by selling them back to the broker-dealer that sold them in the first place.
The broker-dealer will then buy the underlying securities and destroy the ETF shares. This process helps keep the number of outstanding shares consistent, which ensures that the ETF price will not deviate significantly from its NAV.
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