ETFs vs stocks: Key differences explained

When it comes to investing, investors today are spoiled for choice. From traditional investment avenues like fixed deposits, gold, and real estate to newer options like stocks, mutual funds and ETFs, there's a wide array of products to choose from. However, two of the most popular instruments among investors are stocks and ETFs.

While both offer ways to invest in the financial markets, stocks and ETFs have some key differences. Read on for a break down the key distinctions between investing in individual stocks versus exchange-traded funds (ETFs) in India.

What are ETFs?

ETFs or exchange-traded funds first emerged in India back in 2001 when Benchmark Mutual Fund introduced the country's first gold ETF - Gold BeES. But the ETF market really took off after 2009-10. ETFs now let investors get exposure to a basket of securities like stocks, bonds, commodities etc. in a single fund that is listed on the exchanges.

For example, Nifty ETFs track the Nifty50, giving you exposure to the top 50 companies on NSE. Other types of ETFs might track a particular sector like IT, pharma or banking. Similar to mutual funds, each ETF unit you buy represents a portion of the underlying portfolio. But unlike traditional mutual funds, ETFs trade on the exchanges so you can buy and sell whenever you want during market hours.

Read More: How ETFs Help You Diversify Your Portfolio?

What are stocks?

Stocks or equities represent ownership shares in individual listed companies on exchanges like NSE and BSE. When you buy a stock, you become a shareholder entitled to a portion of the company's earnings and voting rights. Investors have been trading stocks for decades, purchasing shares of companies they believe will rise in value over time.

For instance, popular Indian stocks like Reliance, Infosys, HDFC Bank and Tata Motors are household names. Investors do research on factors like earnings, management team and competitive advantages to pick stocks they think will outperform.

Now that the meaning and concept of ETFs and stocks have been laid down, let's examine some key differences.

• Diversification

The biggest contrast between ETFs and stocks is diversification. ETFs automatically spread your investment across multiple securities within a single fund. For example, a Nifty ETF provides exposure to 50 large Indian companies.

But when you purchase an individual stock, your entire investment depends on just that one company. So if that stock underperforms, your portfolio takes a big hit. ETFs reduce this concentration risk through built-in diversification.

• Costs

ETFs tend to have lower costs than actively managed mutual funds. The average expense ratio for index ETFs is around 0.5% whereas active funds are closer to 2%. For stocks, you must pay brokerage commissions and STT whenever you buy or sell. These trading costs add up over time.

However, several brokers now offer commission-free ETF and stock trading in India. So, for buy-and-hold investors, the cost difference may not be very high between the two.

• Taxation

The 2024 Union Budget introduced significant changes to the taxation of ETFs and stocks in India. Short-term capital gains (STCG) on equity ETFs and stocks are now taxed at 20%, up from 15%, while long-term capital gains (LTCG) are taxed at 12.5%, with the exemption limit raised to ₹1.25 lakh. For non-equity ETFs (e.g., gold, debt), LTCG is also taxed at 12.5% without indexation benefits, replacing the earlier 20% rate with indexation. These changes reduce the tax efficiency advantage of ETFs over stocks for short-term traders, though ETFs still offer diversification benefits and lower costs for long-term investors. However, buy-and-hold stock investors may benefit from zero STT on delivery-based investments, which does not apply to ETFs.

• Liquidity

Both ETFs and stocks trade continuously on the exchanges offering high liquidity during market hours. However, some smaller stocks may face light trading volumes and wide bid-ask spreads. Overall, ETFs and large-cap stocks enjoy ample liquidity for entering and exiting positions when needed.

• Returns

ETF returns closely mirror the index or sector they track. Actively managed mutual funds aim to outperform the market but may not always succeed. Individual stock returns vary based on your picking ability. So, while stock picking provides the potential to beat the market, it requires skill and diligent research. Passive ETFs offer diversified market-like returns across the board.

Conclusion

ETFs provide diversified exposure to indices or sectors at low costs in a tax-efficient structure. Individual stocks allow concentrated bets on companies you believe will outperform. As an investor, a balanced portfolio holding both ETFs for core stability and selective stocks for higher returns can be an ideal combination.