ETFs vs. Mutual Funds for Young Investors: An Overview
Which is better for young investors, exchange-traded funds (ETFs) or mutual funds? That depends on a number of factors. They include how much a young investor has to invest, how actively involved they want to be with their investments, and their understanding of the advantages and disadvantages of each option.
Both types of funds offer instant diversification and professional management of fund assets. They both involve less risk (and greater convenience) than investing in individual securities.
ETFs are a newer option for investors and they were originally known for having far lower fees than comparable mutual funds. That gap has closed in recent years as mutual funds work to attract new investors.
Key Takeaways
- Many mutual funds are actively managed while most ETFs are passive investments that track the performance of a particular index.
- ETFs can be more tax-efficient than actively managed funds due to their lower turnover and fewer transactions that produce capital gains.
- ETFs are bought and sold on an exchange throughout the day while mutual funds can be bought or sold only once a day at the latest closing price.
- Many online brokers offer commission-free ETFs regardless of the size of the account. Some mutual funds require a minimum initial investment.
- It is generally cheaper to buy mutual funds directly through a fund family than through a broker.
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ETFs vs. Mutual Funds: Which Is Right for Me?
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Understanding Investor Goals and Preferences
Before we dig into ETFs versus mutual funds, there are a few important things to cover. First, young investors must identify their investment goals. The financial targets they set may play a factor in what investment vehicle they choose.
Another factor to consider related to this is an investor's appetite for risk. Investors may intentionally choose to invest in something riskier or less tax-advantaged for specific reasons; they may prioritize certain types of investment growth or other investment strategies.
As you read more about ETFs and mutual funds, take care in thinking through what type of investor you are, what your long-term goals are, and what financial priorities (i.e. reduce taxes, maximize gains, etc) are on your list.
ETFs
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 rapidly in popularity since then.
You can buy ETFs through virtually any online broker, while not all mutual funds are 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, most are passive investments that mimic the contents of an index. The return should be nearly identical to the return of the index.
As such, they can be appropriate for investors with a long-term buy-and-hold investment strategy who prefer passive over active management.
ETFs are generally lower than those that are charged by actively managed mutual funds because their managers are merely mimicking the contents of an index rather than making regular buy and sell decisions,
For some investors, the design of a passive ETF is a negative. The stated purpose of the ETF is not to beat an index but to match it. Investors who want to maximize their returns and beat the indices are not best served by ETFs.
Young investors must decide how actively they'll buy and sell ETFs. Active trading increases fees and decreases returns.
Mutual Funds
While not as hip as ETFs, mutual funds can be a great investment option. You can purchase them directly from the company that issues the fund.
Most companies 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 Advisor (CFA), CFP, andfounder of Golden Bell Financial Planning.
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. 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 or emerging markets. In such circ*mstances, active managers try to take advantage of price inefficiencies to boost the fund's returns.
Bear in mind that active management results in added costs and an annual performance that may fall 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 depending on the fund. Extremely popular funds are often closed to new investors because their vast size can make them inefficient. Rest assured, comparable funds are available from the company or its competitors.
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.
| ETFs | Mutual Funds | |
|---|---|---|
| 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 |
| Professionally managed | Yes | Yes |
| 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.
You may be better suited for an ETF:
- If passive management fits your investment style and you want 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.
You may be better suited for a mutual fund:
- If you seek to outperform the market by having your money actively managed.
- 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.
Consider Both ETFs and Mutual Funds
Owning both types of funds may be a smart strategy 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 many not setting a required minimum investment.
Are ETFs Good for First-Time Investors?
ETFs can be a great choice for first-time investors of any age. Most ETFs are funds that pool investor money and then use it to buy individual securities, matching the listings in an index. The returns will be near-identical to the index or other indicator.
ETFs are professionally managed and traded throughout the day on exchanges. They don't require a minimum investment because they trade as shares.
A huge variety is available, including ETFs that track the major indexes and specialized indexes for sectors, industries, and regions. The biggest ETF of all is the S&P 500 (SPY) Index.
What Are Two Disadvantages of ETFs?
A passively managed ETF is designed to track an index, not beat it. If your goal is to beat the index, the ETF isn't for you. You need to choose an actively managed fund or pick your own stocks.
Another disadvantage of some funds, particularly highly specialized ones, is low trading volume. This results in wider bid-ask spreads, meaning you may not be able to buy or sell shares at the price you expect. Wide bid-ask spreads can also represent a hidden cost that you may not realize exists. It's a good idea to check on trading volume before you decide to buy a particular ETF.
The Bottom Line
For young investors, ETFs and mutual funds can offer tremendous investment opportunities. Which of the two is the best choice depends on the individual investor's financial goals, investing style, and overall strategy for reaching their financial goals.
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 want 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.
