You may think that owning stocks involves picking the companies you want to buy and phoning up your broker (or logging into your brokerage account) and telling them how many shares you want to buy.
Holding shares of stock this way is known as direct stock ownership. And while buying stocks individually is definitely one way to invest, it's not the only way.
Many people invest in the stock market primarily through mutual funds and/or exchange-traded funds (ETFs) This gives them indirect stock ownership. (To keep things simple, in this article we'll refer to mutual funds and ETFs generically as “funds,” even though not all funds hold stocks.)
These investors are just as exposed to the ups and downs of the individual stocks in their funds as if they had bought each of them individually. And they most likely paid much lower fees and commissions than if they had bought each stock directly. However, these investors do not enjoy the benefits of direct stock ownership.
This article describes the differences between direct and indirect stock ownership. Indirect ownership using funds has many benefits. But we'll show why it can lead to surprises in terms of your total stock ownership.
We'll also touch on why it is important to know the special definitions of direct vs. indirect ownership if you have access to “inside information” about a company.
Surprise — You May Have a Lot of Your Money in Just a Few Stocks
Although you may not buy any individual stocks directly, you may own funds through a 401(k) plan or an IRA or even in a non-retirement brokerage account. A fund gives you indirect ownership of each and every stock it holds. It could include hundreds of different companies. And you bought all of them by making just one transaction.
The percentage of the fund's money that ends up in each individual stock in the fund depends on the fund manager's decisions. You may be surprised by how much of a particular stock you indirectly own. It all depends on the similarities among the funds you hold
For example, let's imagine you have a 401(k) with $20,000 invested in Fund A and $30,000 in Fund B. The managers of Fund A have invested 15% of their investors' money in XYZ Co.'s stock because they believe it will deliver strong returns. It turns out that Fund B has invested 10% of its total in XYZ Co. shares. So, although you did not buy any XYZ Co. stock directly, 12% of your $50,000 is invested in XYZ's stock.
So indirect ownership can make your exposure to a given stock greater than you might realize. And this is especially true if you also own shares of that stock directly. It's like agreeing to buy assortments of fruit and vegetables from two different food delivery services, and it turns out they both put a lot of zucchini in their boxes. Even if you like zucchini, you may end up with more than you want.
Most funds disclose their top 10 holdings to investors. But mutual funds do not have to disclose all of their holdings, and most don't. So owning stocks indirectly through funds means you probably won't know exactly what you own.
Direct or Indirect — How Do You Know?
How do you know whether your stock ownership is direct or indirect? The primary consideration is whether or not you control the stock's voting rights. Remember, among other rights of ownership, shareholders elect the company's board of directors.
This is potentially a big deal, since the board works for the shareholders and company management reports to the board. With direct stock ownership, you control those voting rights. Activist shareholders can pressure the board and company management to make significant changes in the way the business is run.
But shares of stock do not have to be held in your personal brokerage account or 401(k) to be classified as directly owned. Individual stocks held in a trust or partnership that you control are classified as direct ownership, because you can vote as a shareholder.
Privileges of Direct Stock Ownership
With direct stock ownership:
- You have voting rights that could impact the company's management.
- You control whether and when to realize capital gains or losses by selling shares. And you can (usually) specify which shares you sell to maximize or minimize that gain or loss. This can be quite valuable for tax planning.
- You decide when to increase or decrease the amount of your money invested in the stock and even when to ditch the stock completely, unless your ownership is through a trust or partnership with rules that restrict stock sales.
If you own shares through a fund, you do not have voting rights for the stocks the fund owns. So your ownership is indirect. You have voting rights for the shares of the fund. This includes the right to approve the fund's board of directors. But the fund is the direct owner of the individual stocks it holds. And the fund has the right to vote on shareholder issues. In terms of tax planning, ETFs usually attempt to minimize the fund's realized capital gains. A mutual fund may or may not do so, depending on its particular strategy.
Indirect ownership also occurs when you own shares of Company A, which owns shares of Company Z. This can happen with publicly traded firms or with private companies. You may recall that Yahoo owned 15% of the huge Chinese e-commerce company Alibaba before Alibaba was a publicly traded company. Therefore, Yahoo shareholders were indirect owners of Alibaba.
Insider Trading — A Different Definition of Direct Ownership
The term “indirect ownership” has a different meaning when it comes to insider trading rules.
It is illegal to trade a company's stock based on inside information (i.e., information that has not been made available to the general public).
As an employee or a friend or relative of an employee or a consultant or auditor or lawyer working for a company, you may have access to non-public information. You can be criminally prosecuted for trading the company's stock based on inside information, even if the shares traded are held in an account that is not in your name and which you don't control.
Shares controlled by any immediate family member would be considered “indirectly owned” by you, but the term is used differently than what was discussed above.
When comparing direct versus indirect ownership, it is not a matter of “better or worse.”
Owning shares directly gives you a great deal of control over your investment life. But it comes with the responsibility of selecting, monitoring and deciding when to buy and sell those individual stocks. And you also get to vote your shares. Many investors prefer indirect ownership, outsourcing all of that to the professionals who manage mutual funds and ETFs.
Ultimately, when it comes to stock ownership, it's OK to be direct or indirect, whichever suits your needs.