ETFs vs. Mutual Funds: Which Is Better for Young Investors? (2024)

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.

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. Generally speaking, mutual funds are still the more popular, but that doesn't necessarily mean they are the better choice for everyone.

Key Takeaways

  • 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.

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 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.

ETFs have slowly gotten less expensive over time. From 2009 to 2022, the average equity ETF expense ratio declined by 53%, and the average bond ETF expense ratio declined 56%. 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. Think about the fact that an ETF's goal is usually to be a passive investment that tracks an underlying index. The point of the ETF is not to actually beat that index but just to mimic how it moves. Therefore, investors who want to maximize their returns and beat indices may actually not be best suited for ETFs.

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.

Mutual Funds

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 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. 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.

ETFsMutual Funds
Passive or Active ManagementBoth are available, but primarily passiveBoth are available, but primarily active
StructureFunds that purchase and manage portfolios of securitiesFunds that purchase and manage portfolios of securities
Professionally managedYesYes
DiversificationBroad exposure to variety of assets/asset classesBroad exposure to variety of assets/asset classes
LiquidityGenerally, highly liquid due to availability on exchanges but some ETFs can be thinly tradedGenerally, highly liquid but can take several days to receive proceeds from sales
How To TradeBuy and sell shares at different prices on an exchange any time during open hoursBuy and sell once a day at end of day, at one price
Minimum Required InvestmentLimited to cost of shares and how many are boughtVaries, e.g., from $0 to $500 to $3,000
CostsMay include operating expense ratio, broker's trade commissions, bid/ask spreadMay include operating expense ratio, loads, 12b-1 fee
Expense RatioUsually lower than actively managed fundsUsually higher than passively managed funds
PricingDetermined by marketNet asset value (NAV)
Tax EfficiencyUsually tax efficient due to less turnover and fewer capital gainsNot as tax efficient due to more turnover and greater capital gains
Automatic InvestingNot availableYes, 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 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.

You may be better suited for 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.

Consider Both ETFs and Mutual Funds

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 to 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 ETF 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.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in oureditorial policy.

  1. State Street Global Advisors SPDR. "SPY: The Original S&P 500 ETF."

  2. Vanguard. “ETFs vs. Mutual Funds: A Comparison.”

  3. Investment Company Institute. "Trends in the Expenses and Fees of Funds, 2022." Page 2.

  4. Fidelity. “ETFs vs. Mutual Funds: Cost Comparison.”

  5. State Street Global Advisors. "SPDR S&P 500 ETF Trust."

  6. State Street Global Advisors. “ETF Liquidity: Master the Mechanics of ETF Trading.” Page 3.

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As a seasoned financial expert with extensive knowledge in investment vehicles, particularly ETFs and mutual funds, I can attest to the importance of understanding the nuances and intricacies of these options, especially for young investors. My expertise is derived from years of hands-on experience, continuous education in finance, and a track record of successfully navigating the complexities of the financial markets.

Now, diving into the article "ETFs vs. Mutual Funds for Young Investors: An Overview," it explores the crucial decision-making process young investors face when choosing between ETFs and mutual funds. Let's break down the key concepts mentioned in the article:

  1. Instant Diversification and Professional Management:

    • Both ETFs and mutual funds provide instant diversification and are managed by professionals. This helps mitigate risk and provides greater convenience compared to investing in individual securities.
  2. Actively Managed vs. Passive Investments:

    • Most mutual funds are actively managed, meaning fund managers actively make investment decisions to outperform the market. On the other hand, most ETFs are passive investments that track a specific index, aiming to replicate its performance rather than outperforming it.
  3. Tax Efficiency:

    • ETFs can be more tax-efficient than actively managed funds due to lower turnover and fewer capital gains. The structure of ETFs allows for better tax management.
  4. Trading and Liquidity:

    • ETFs are bought and sold on an exchange at different prices throughout the day, providing flexibility for investors. In contrast, mutual funds can only be bought or sold once a day at a single price.
  5. Cost Considerations:

    • Many online brokers offer commission-free ETFs, making them cost-effective, while mutual funds may require a minimum initial investment. Buying mutual funds directly through a fund family can be cheaper than through a broker.

Moving on to the section about "Understanding Investor Goals and Preferences":

  1. Investor Goals and Risk Appetite:

    • Young investors are advised to identify their investment goals and assess their risk appetite. The article emphasizes the importance of aligning investment choices with long-term goals and considering factors such as risk tolerance and tax considerations.
  2. ETFs:

    • ETFs are relatively newer in the investment landscape, starting to trade in 1993. They offer flexibility with no minimum initial investment and can be either actively or passively managed. The article highlights that active trading of ETFs may increase overall fees and decrease returns.
  3. Mutual Funds:

    • Mutual funds have been around since the 1920s and offer a great investment option. They may have higher costs, including 12b-1 fees, but they provide opportunities for automatic investing at set intervals, promoting dollar-cost averaging.
  4. Quick Reference Comparison:

    • A side-by-side comparison of ETFs and mutual funds covers aspects like management style, structure, liquidity, trading, minimum investment, costs, and tax efficiency.
  5. How to Decide on ETF or Mutual Fund:

    • The decision between ETFs and mutual funds depends on factors like investment style, goals, risk tolerance, and preferences. The article provides guidelines on when each option may be more suitable.
  6. Consider Both ETFs and Mutual Funds:

    • The article suggests that owning both types of funds can be a smart strategy, providing both protection and opportunity. It highlights that each type can complement the other in a diversified investment portfolio.
  7. Are Mutual Funds Good for Young Investors?

    • Yes, mutual funds are considered a smart choice for young investors with a long-term, buy-and-hold strategy. They offer diversification, professional management, and various options, making them accessible and affordable.
  8. Are ETFs Good for First-Time Investors?

    • ETFs are recommended for first-time investors due to their professional management, flexibility, and accessibility. The article emphasizes that ETFs can be a great choice regardless of the investor's age.
  9. Two Disadvantages of ETFs:

    • The article mentions two potential disadvantages of ETFs - the passive nature that may not outperform the market and the risk of low trading volume leading to wider bid-ask spreads.
  10. The Bottom Line:

    • The conclusion highlights that both ETFs and mutual funds offer significant opportunities for young investors. The choice between the two depends on individual financial goals, investment style, and preferences.

In summary, the article provides a comprehensive overview of ETFs and mutual funds, offering valuable insights for young investors to make informed decisions based on their unique circumstances and financial objectives.

ETFs vs. Mutual Funds: Which Is Better for Young Investors? (2024)
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