ETFs vs. Mutual Funds for Young Investors: An Overview
Which is better for young investors, ETFs or mutual funds? That depends on a number of factors. Some of those include how much a young investor has to invest, how actively involved they want to be with their investments, whether they know how markets function, and their understanding of the advantages and disadvantages of each option.
Young investors must also identify their investment goals and learn about exchange-traded funds (ETFs) and mutual funds to pinpoint whether one or the other could be the right investment for their specific needs.
Here's some background. These investment funds pool investor deposits and then purchase a wide variety of individual stocks, bonds, or other assets. They then sell shares of the funds to investors.
Both types of funds offer instant diversification and professional management of fund assets. They both involve less risk (and greater convenience) compared with investing in individual securities. Moreover, the great variety of ETFs and mutual funds can offer varying degrees of risk and return to suit different investor goals. Mutual funds are still the more popular, by far. But ETFs are catching up.
Read on to learn which type of fund may be better for you, as a young investor.
- Most mutual funds are actively managed while most ETFs are passive investments that track a particular index.
- ETFs can be more tax-efficient than actively managed funds due to lower turnover and fewer capital gains.
- ETFs are bought and sold on an exchange at different prices throughout the day while mutual funds can be bought or sold only once a day at one price.
- Many online brokers now offer commission-free ETFs, regardless of the size of the account; mutual funds may require a minimum initial investment.
- It is generally cheaper to buy mutual funds directly through a fund family than through a broker.
While mutual funds have been around since the 1920s, ETFs are the newer kid on the investing block. They started trading in 1993 and have grown in popularity since then. You can buy ETFs through virtually any online broker, whereas mutual funds aren’t always available through brokers. ETFs don't require a minimum initial investment because they trade as individual shares. You can buy a single share, if you choose to.
ETFs can be either actively or passively managed. However, the majority are passive investments that track a major index instead of trying to beat the market. As such, they can be appropriate for investors with a long-term buy-and-hold investment strategy who prefer passive over active management.
The average expense ratios of index equity ETFs declined to 0.16% in 2021, compared to 0.34% in 2009. Generally, these ETF fees are lower than those charged by actively managed mutual funds.
For some investors, the very design of a passive ETF is a negative. Brent D. Dickerson, certified financial planner (CFP) and founder of Trinity Wealth Management, says, "The drawback to an ETF is that it will do what the index it is tracking does. So, for example, if you invest in an ETF that tracks the S&P 500, if it loses 40% of its value, then so will the ETF."
"With a mutual fund, the manager is not typically invested in the exact same assets as the index . . . and so, there is a possibility of doing better than the ETF. The same holds true for up markets. If the index increases 40% so will the ETF. Actively managed mutual funds may see outperformance of the index, but this is never something that can be duplicated time and time again over long periods of time."
Young investors should decide how actively they'll buy and sell ETFs. That's because active trading may lead to an increase in their overall fees and can decrease their returns.
While not as hip as ETFs, mutual funds also can be a great investment option. They may not be available through all brokerages, but you can purchase them directly from the fund family. Most fund families make it easy to invest money at set intervals, which is a great feature for young investors trying to establish a consistent investing pattern. It's also an opportunity to take advantage of dollar-cost averaging.
"They can go to a low-cost fund company like Vanguard and set up an automatic investment program where perhaps $100 is pulled from their checking account every two weeks and invested in a Roth IRA. They can set this up with a few minutes of work and then simply let the investment program happen,” says Jason Lina, Chartered Financial Analyst (CFA), CFP, and lead advisor with Resource Planning Group.
Mutual funds are still more expensive than ETFs, but there is a reason for that. They include 12b-1 fees, which essentially are compensation for advisors' efforts to sell a given fund.
Mutual funds can be either actively or passively managed. Most are actively managed. For investors who seek an investment that attempts to outperform the market, an actively managed fund may be the way to go.
Actively managed mutual funds can be attractive to those targeting inefficient markets (e.g., emerging markets). In such circumstances, active managers try to take advantage of price inefficiencies to boost returns.
Bear in mind that active management can result in added costs and an annual performance that falls short of the overall market. An actively managed fund is also typically less tax-efficient due to the capital gains generated as a manager buys and sells securities to try to outperform the market.
Many, but not all, mutual funds require minimum amounts to open an account. You may see a range of $100 to $3,000.
Quick Reference Comparison
All investors, whether they're just starting out or highly experienced should be sure to read fund materials carefully for all pertinent details about a potential investment and to compare one to another. In the meantime, here's a summary of ETF and mutual fund basics that highlights their similarities and differences.
|Passive or Active Management||Both are available, but primarily passive||Both are available, but primarily active|
|Structure||Funds that purchase and manage portfolios of securities||Funds that purchase and manage portfolios of securities|
|Diversification||Broad exposure to variety of assets/asset classes||Broad exposure to variety of assets/asset classes|
|Liquidity||Generally, highly liquid due to availability on exchanges but some ETFs can be thinly traded||Generally, highly liquid but can take several days to receive proceeds from sales|
|How to Trade||Buy and sell shares at different prices on an exchange any time during open hours||Buy and sell once a day at end of day, at one price|
|Minimum Required Investment||Limited to cost of shares and how many are bought||Varies, e.g., from $0 to $500 to $3,000|
|Costs||May include operating expense ratio, broker's trade commissions, bid/ask spread||May include operating expense ratio, loads, 12b-1 fee|
|Expense Ratio||Usually lower than actively managed funds||Usually higher than passively managed funds|
|Pricing||Determined by market||Net asset value (NAV)|
|Tax Efficiency||Usually tax efficient due to less turnover and fewer capital gains||Not as tax efficient due to more turnover and greater capital gains|
|Automatic Investing||Not available||Yes, for investments and withdrawals|
How to Decide on an ETF or a Mutual Fund
Which investment to buy depends on your financial needs, investment goals, tolerance for risk, and investment style. Carefully consider those factors, as well as the highlights below, to determine whether an ETF or a mutual fund is right for you.
Consider an ETF
- If passive management fits your investment style and you can accept whatever return the index offers
- If you want lower operating expense ratios
- If you plan to trade shares actively and prefer the access and price movements an exchange provides
- If tax efficiency is a priority
Consider a Mutual Fund
- If you seek to outperform the market with active management
- If the potential for higher returns outweighs the higher fees
- If you want to invest the same dollar amount automatically at regular intervals
- If your target market is inefficient and may benefit from active managers seeking to capitalize on that characteristic
Owning both types of funds may be a smart strategy, too, as each can offer protection and opportunity.
For example, if you own a passively-managed ETF, also buying an actively-managed mutual fund may offer you some upside potential beyond that of the index being tracked. If you own an actively-managed mutual fund, also buying a passively-managed ETF may protect against the downside risk and volatility associated with an actively-managed mutual fund.
Are Mutual Funds Good for Young Investors?
Yes. For young investors with a long-term, buy-and-hold investment strategy, mutual funds can be a smart place to put their money. They have been around for many years and have stood the test of time as investments. They offer immediate diversification, professional management, and passive or actively managed fund choices. You don't have to buy individual stocks, bonds, or other assets yourself. Plus, they're affordable, with a range of required minimum amounts from $0 on up.
Are ETFs Good for First-Time Investors?
ETFs can be a great choice for first-time investors, no matter what your age is. ETFs are funds that pool investor money and then use it buy a variety of individual securities (so you don't have to). They are professionally managed and trade throughout the day on exchanges. They don't require a minimum investment because they trade as shares. The majority of ETFs are passively managed funds that simply track an index. For instance, the SPDR S&P 500 ETF (SPY) tracks the S&P 500 Index.
What Are Two Disadvantages of ETFs
One possible disadvantage is that a passively-managed ETFs is designed to track an index. That means it typically will not outperform it. If your goal is to beat the market, then an ETF may not meet your needs. Another disadvantage is the potential for low trading volume. This results in wider bid-ask spreads. In turn, that can mean that you may not be able to buy or sell shares at the price you expect. It's a good idea to check on trading volume before you decide to buy a particular ETF. Wide bid-ask spreads can also represent a hidden cost that you may not realize exists.
The Bottom Line
For young investors, ETFs and mutual funds offer tremendous investment opportunities. Which of the two is the best choice depends on an individual investor's financial goals, investing style, their overall investment strategy for reaching their goals, acceptable costs, and more.
Young investors shouldn't feel limited to selecting one or the other type of fund. They can invest in both if they're targeting different markets, or to invest passively as well as actively. No matter which type you choose, be sure to read a particular fund's prospectus to learn all about it.
Investment Company Institute. "Trends in the Expenses and Fees of Funds, 2021."