ETFs vs. Mutual Funds for Young Investors: An Overview
It can be difficult for young people to start investing. They may be dealing with limited funds, student loan debt, or lack of knowledge about how investing in the stock market works. On top of that, they face an industry that’s more interested in advertising to them than educating them as to what may be the best options to consider.
That should not hold young investors back from getting into the market. Rather, they should educate themselves and find the best investment vehicle to suit their needs. With that in mind, many young investors will hear about exchange-traded funds (ETFs) and mutual funds and wonder which may be best. There is no simple answer to that question, although there are some things to keep in mind when deciding between the two.
- Most mutual funds are actively managed rather than passively tracking an index. That can bring added value to a fund.
- Many online brokers now offer commission-free ETFs, regardless of the size of the account. Mutual funds may require a minimum investment.
- When following a standard index, ETFs are more tax-efficient and more liquid than mutual funds. This can be great for investors looking to build wealth over the long haul.
- It is generally cheaper to buy mutual funds directly through a fund family than through a broker.
ETFs are the new(er) kid on the investing block. They started trading in 1993 and have grown in popularity since. There are many things to like about ETFs, such as:
- They are generally cheaper than their mutual fund siblings, although the gap is closing due to intense competition. The expense ratios of equity mutual funds declined to 0.55% in 2018, compared to 0.99% in 1997. ETF expense ratios also fell, to just 0.20%.
- ETFs are generally passive and track an index rather than actively buying and selling in an effort to beat the index.
- You can buy ETFs through virtually any online broker, whereas mutual funds aren’t always available through brokers.
There are some other significant differences between ETFs and mutual funds, though the above list provides a good high-level view that will benefit most young investors. For those who have a hard time meeting the initial minimums for mutual funds, ETFs can be a great alternative.
This is especially the case if they pursue a long-term buy-and-hold strategy of sticking to mainstream indices.
While cheaper expense ratios and less turnover are good, it’s not true of all ETFs. In fact, the ETF craze has led some to create ETFs that track obscure indices that trade infrequently. The commission-free ETFs can be good, but in some instances, they’re lacking in solid index funds that track a known index.
Young investors should consider is how actively they plan to trade ETFs because active trading will lead to an increase in their overall fees.
Another potential drawback to an ETF is that it is designed to track an index, not exceed its performance. Brent D. Dickerson certified financial planner (CFP), 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."
While not as hip as ETFs, mutual funds 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 drip in money on set intervals, which is a great feature for young investors trying to establish a consistent investing pattern.
"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 more expensive, but there is a reason for that. They include 12b-1 fees, which essentially are compensation for advisors selling a given fund. Mutual funds are generally actively managed. Active management is not a bad thing per se, though it can bring added costs plus the risk of underperforming the overall market.
Many mutual funds have minimums to open an account. In many instances that may be $1,000 or $2,500, so you’re not able to invest in the given fund unless you have that amount of money to invest. For the young investor just starting out, this can hold them back when they otherwise could be investing in an ETF.