Should You Invest in an Index ETF or Directly in Shares?

One of the most common questions people ask is should they invest in Index ETFs rather than in shares directly. The reason investors want to invest in Index ETFs is because of the ease of investing in just one ETF rather than lots of different shares. But when asked why they are investing in the first place, their response is always to achieve good returns at lower risk, and rightly or wrongly, investors believe Index ETFs can deliver on these goals. So, what’s the reality – are you better off investing in an Index ETF or directly in shares?

Do Index ETFs deliver on investors goals?

Index ETFs aim to track the returns of an underlying index such as the S&P ASX Top 200 or Top 300. To give you some perspective, I reviewed the three biggest index ETFs in Australia and found that Vanguards VAS Index ETF achieved a one year total return last year of minus 1.78 per cent. State Streets STW Index ETF achieved a total return of minus 1.05 per cent while Black Rocks IOZ Index ETF returned minus 1.07 per cent.

You may be asking what about the income from ETFs? While ETFs will generally pay income distributions quarterly, the figures quoted for the above Index ETFs are the total returns, which means the returns already account for distributions.

While the All Ordinaries Index fell around 3.5 per cent over the same time, you may be thinking that these ETFs did a good job, however, the return on the All Ordinaries Index doesn’t account for income from dividends. With a market average of around 3 to 4 per cent not including franking credits, if we include the income from distributions, you would have achieved a better return if you invested in shares directly.

But let’s be realistic, no one person can buy all 500 shares in the All Ordinaries Index and nor would they want to, but they can buy the top 20 stocks quite easily. If we look at the S&P ASX 20 index (XTL), which is the 20 largest companies in the Australia market, the one-year return last year for this index was minus 1.83 per cent. But this doesn’t include dividends or franking credits, so if all an investor did was buy the top 20 stocks on 1 January 2022 and held them until 31 December, they would have achieved a better return than the index ETFs quoted above.

Why investing directly will produce better returns

Remember, investors want better returns at lower risk and, as I just demonstrated, investing directly in the top 20 stocks definitely delivers better returns. And given that a lot of investors invest in Index ETFs to simply buy and hold, doing the same with the top 20 stocks will always deliver better total returns.

As for the risk component, the top 20 shares in our market account for around 50 per cent of the total market capitalisation, which is very low risk. So, if an investor is prepared to hold an index ETF for the long term, there is no reason why holding the top 20 stocks long term is any riskier. In fact, I would argue the opposite given that holding direct shares means the investor is not subjected to the counter party risk of the ETF provider.

What were the best and worst performing sectors last week?

The best performing sectors included Information Technology up 2.63 per cent followed by Consumer Discretionary up 1.39 per cent and Consumer Staples up 1.18 per cent. The worst performing sectors included Energy down 2.08 per cent followed by Healthcare down 1.19 per cent and Communication Services down 0.18 per cent.

The best performing stocks in the ASX top 100 included Block up 9.87 per cent followed by ARB Corporation up 9.83 per cent and Allkem up 8.36 per cent. The worst performing stocks included Whitehaven Coal down 10.97 per cent followed by Fisher & Paykel Healthcare down 4.81 per cent and Incitec Pivot down 3.69 per cent.

What's next for the Australian stock market?

January 2023 has been a very good month for the All Ordinaries Index with our market up 6.75 per cent and it is still looking like it will continue to rise. Materials has been the stand out sector this month up over 10 per cent, while Consumer Discretionary is up over 9 per cent but the good news is that Financials is up over 5 per cent.

When both the Materials and Financial sector are moving in the same direction, the market follows, which is why the All Ordinaries Index has been so bullish this month. While we would all like this to continue, we know the good times never last and neither do the bad times.

My expectation is that both the Materials and Consumer Discretionary sectors will start to slow, as will the stock market. The trick for investors is not to jump into stocks just before they slow or turn to trade down, which is often the case. Right now, you need to be looking at sectors that haven’t performed as well, which include Utilities and Energy.

So, where is the market headed? In the past 17 trading days, the All Ordinaries Index has traded up closing lower on only three of those days in a very bullish display. That said, over the past six trading days, the upward momentum has slowed and I expect this to continue. I still expect the Australian stock market to trade higher into February or March and up to around 7,800 points and beyond although we can expect one or two down weeks in the next month before rising to the next major high.

Dale Gillham is Chief Analyst at Wealth Within and international bestselling author of How to Beat the Managed Funds by 20%. He is also author of the bestselling and award winning book Accelerate Your Wealth—It’s Your Money, Your Choice, which is available in all good book stores and online.